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MACROECONOMICS
Paul Krugman
MACROECONOMICS
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When it comes to explaining fundamental economic principles by drawing on current
economic issues and events, there is no one more trusted than Nobel laureate and New York
Times columnist Paul Krugman and co-author, Robin Wells. In this best-selling introductory
textbook, Krugman and Wells’ signature storytelling style and uncanny eye for revealing
examples help readers understand how economic concepts play out in our world.
WORTH
FOURTH EDITION
Robin Wells
CHAPTER
CHAPTER-OPENING STORIES
W
RLD VIE
O
W
Applications in Macroeconomics
GLOBAL COMPARISONS
1: First Principles, 5
1: Common Ground, 5
2: Economic Models: Trade-offs
2: From Kitty Hawk to Dreamliner, 25
2: Pajama Republics, 37
3: Supply and Demand, 67
3: NEW: A Natural Gas Boom, 67
3: Pay More, Pump Less, 71
4: Price Controls and Quotas:
4: Big City, Not-So-Bright Ideas, 103
4: Check Out Our Low, Low Wages!, 116
5: International Trade, 131
5: NEW: The Everywhere Phone, 131
5: Productivity and Wages Around the
6: Macroeconomics: The Big Picture,
6: NEW: The Pain in Spain, 169
6: NEW: Slumps Across the Atlantic, 177
7: GDP and the CPI: Tracking the
7: The New #2, 191
7: GDP and the Meaning of Life, 204
8: Unemployment and Inflation, 217
8: NEW: Hitting the Braking Point, 217
8: Natural Unemployment Around the OECD,
9: Long-Run Economic Growth, 245
9: NEW: Airpocalypse Now, 245
9: NEW: What’s the Matter with Italy? 260
10: Savings, Investment Spending,
10: Funds for Facebook, 279
10: NEW: Bonds Versus Banks, 299
11: Income and Expenditure, 317
11: From Boom to Bust, 317
12: Aggregate Demand and Aggregate
12: NEW: What Kind of Shock?, 349
12: Supply Shocks of the Twenty-first
13: Fiscal Policy, 385
13: How Big Is Big Enough?, 385
13: The American Way of Debt, 404
14: Money, Banking, and the Federal
14: NEW: Funny Money, 419
14: The Big Moneys, 421
15: Monetary Policy, 455
15: NEW: The Most Powerful Person in
15: Inflation Targets, 470
16: Inflation, Disinflation, and
16: Bringing a Suitcase to the Bank, 485
16: Disinflation Around the World, 502
17: Crises and Consequences, 513
17: From Purveyor of Dry Goods to Destroyer
18: Macroeconomics: Events and
18: A Tale of Two Slumps, 539
19: Open-Economy Macroeconomics,
19: Switzerland Doesn’t Want Your Money,
and Trade, 25
Meddling with Markets, 103
169
Macroeconomy, 191
and the Financial System, 279
Supply, 349
Reserve System, 419
Deflation, 485
Ideas, 539
563
Government, 455
World, 137
230
Century, 372
of Worlds, 513
563
19: Big Surpluses, 569
Blue type indicates global example
ECONOMICS IN ACTION
BUSINESS CASES
1: Boy or Girl? It Depends on the Cost, 10 n Restoring Equilibrium on the Freeways, 17 n
1: How Priceline.com Revolutionized the Travel
Adventures in Babysitting, 20
Industry, 21
2:Rich Nation, Poor Nation, 39 n Economists, Beyond the Ivory Tower, 43
2:Efficiency, Opportunity Cost, and the Logic of
3: Beating the Traffic, 78 n Only Creatures Small and Pampered, 85 n The Price of
3: NEW: An Uber Way to Get a Ride, 97
4: NEW: Price Controls in Venezuela: “You Buy What They Have,” 110 n NEW: The Rise and
4:Medallion Financial: Cruising Right Along, 124
5: NEW: How Hong Kong Lost Its Shirts, 140 n Trade, Wages, and Land Prices in the Nineteenth
5: Li & Fung: From Guangzhou to You, 158
Admission, 89 n NEW: The Cotton Panic and Crash of 2001, 95
Fall of the Unpaid Intern, 116 n NEW: Crabbing, Quotas, and Saving Lives in Alaska, 122
Century, 147 n Trade Protection in the United States, 151 n Beefing Up Exports, 156
6: Fending Off Depression, 172 n Comparing Recessions, 178 n A Tale of Two Countries,
180 n A Fast (Food) Measure of Inflation, 182 n NEW: Spain’s Costly Surplus, 184
7: Creating the National Accounts, 201 n Miracle in Venezuela?, 205 n Indexing to the
CPI, 209
Lean Production at Boeing, 45
6: NEW: The Business Cycle and the Decline of
Montgomery Ward, 186
7: Getting a Jump on GDP, 211
8: Failure to Launch, 223 n Structural Unemployment in East Germany, 232 n Israel’s
8: NEW: Day Labor in the Information Age, 240
9: India Takes Off, 249 n NEW: Is the End of Economic Growth in Sight?, 256 n NEW: Why Did
9: NEW: How Boeing Got Better, 274
Experience with Inflation, 239
Britain Fall Behind?, 262 n Are Economies Converging?, 266 n NEW: The Cost of Limiting
Carbon, 272
10: Sixty Years of U.S. Interest Rates, 292 n Banks and the South Korean Miracle,
300 n The Great American Housing Bubble, 306
11: NEW: Sand State Slump, 320 n Famous First Forecasting Failures, 326 n Interest Rates
10: NEW: Grameen Bank: Banking Against
Poverty, 308
11: What’s Good for America Is Good for GM, 341
and the U.S. Housing Boom, 331 n Inventories and the End of a Recession, 339
12: Moving Along the Aggregate Demand Curve, 1979–1980, 358 n NEW: Sticky Wages in
12: NEW: Slow Steaming, 380
the Great Recession, 367 n Supply Shocks Versus Demand Shocks in Practice, 375 n Is
Stabilization Policy Stabilizing?, 378
13: What Was in the Recovery Act?, 392 n NEW: Austerity and the Multiplier,
13: NEW: Here Comes the Sun, 411
396 n Europe’s Search for a Fiscal Rule, 401 n NEW: Are We Greece?, 409
14: The History of the Dollar, 425 n It’s a Wonderful Banking System, 429 n Multiplying
14: The Perfect Gift: Cash or a Gift Card?, 449
Money Down, 434 n The Fed’s Balance Sheet, Normal and Abnormal, 440 n Regulation
After the 2008 Crisis, 447
15: A Yen for Cash, 460 n The Fed Reverses Course, 466 n What the Fed Wants, the Fed
15: PIMCO Bets on Cheap Money, 477
Gets, 471 n International Evidence of Monetary Neutrality, 475
16: Zimbabwe’s Inflation, 491 n NEW: The Phillips Curve in the Great Recession, 499 n The
Great Disinflation of the 1980s, 503 n NEW: Is Europe Turning Japanese?, 506
16: Licenses to Print Money, 508
17: The Day the Lights Went Out at Lehman, 517 n Erin Go Broke, 522 n Banks and the Great
Depression, 527 n NEW: If Only It Were the 1930s, 532 n Bent Breaks the Buck, 534
18: When Did the Business Cycle Begin?, 540 n The End of the Great Depression, 544 n The
Fed’s Flirtation with Monetarism, 550 n NEW: The 1970s in Reverse, 553 n NEW: Lats
of Luck, 558
19: The Golden Age of Capital Flows, 572 n Low-Cost America, 580 n China Pegs the Yuan,
585 n NEW: The Little Currency That Could, 589
19: NEW: A Yen for Japanese Cars, 591
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MACROECONOMICS
FOURTH EDITION
Paul Krugman
Princeton University
Robin Wells
Vice President, Editorial: Charles Linsmeier
Cover Photos Credits
Publisher: Shani Fisher
Central Photo: Lobby in the rush hour is made in the manner of blur and a blue
tonality: blurAZ/Shutterstock
First Row (left to right): Female Korean factory worker: Image Source/Getty
Images; Market food: Izzy Schwartz/Getty Images; High gas prices in Fremont,
California: Mpiotti/Getty Images
Second Row: Red sports car: Shutterstock; View of smoking coal power plant:
iStockphoto/Thinkstock; Lab technician using microscope: Jim Arbogast/Getty
Images
Third Row: Lightbulbs in box: © fStop/Alamy; Market food: Izzy Schwartz/Getty
Images
Fourth Row: Set of coloured flags of many nations of the world: © FC_Italy/
Alamy; Stack of cargo containers at sunrise in an intermodal yard: Shutterstock;
Depression era photo of man holding sign: The Image Works
Fifth Row: Stock market quotes from a computer screen: Stephen VanHorn/
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Sixth Row: Rear view of people window shopping: Thinkstock; Power plant pipes:
Corbis; Power lines: Brand X Pictures; Three students taking a test: © Royalty-Free/
Corbis; Paper money: Shutterstock
Seventh Row: Woman from the Sacred Valley of the Incas: hadynyah/Getty
Images; Paint buckets with various colored paint: Shutterstock; Close up of hands
woman using her cell phone: Shutterstock; Paper money: Shutterstock
Eighth Row: Cows: Stockbyte/Photodisc; Wind turbine farm over sunset: Ted Nad/
Shutterstock; Wall Street sign: thinkstock; Busy shopping street Center Gai
Shibuya, Tokyo: Tom Bonaventure/Photographer’s Choice RF/Getty Images; Paper
money: Shutterstock
Ninth/Tenth Rows: Waiter in Panjim: Steven Miric/Getty Images; Group of friends
carrying shopping bags on city street: Monkey Business Images/Shutterstock; Set
of coloured flags of many nations of the world: © FC_Italy/Alamy; Soybean Field:
Fotokostic/Shutterstock; Drilling rig workers: Istockphoto; Tropical fish and hard
corals in the Red Sea, Egypt: Vlad61/Shutterstock; Modern train on platform:
Shutterstock
Eleventh/Twelfth Rows: Paper money: Shutterstock; View of smoking coal power
plant: iStockphoto/Thinkstock; Welder: Tristan Savatier/Getty Images; container
ship: EvrenKalinbacak/Shutterstock; Market food: Izzy Schwartz/Getty Images;
Modern train on platform: Shutterstock
Thirteenth Row: Printing U.S. dollar banknotes: Thinkstock; Stock market quotes
from a computer screen: Stephen VanHorn/Shutterstock
Marketing Manager: Tom Digiano
Marketing Assistant: Alex Kaufman
Executive Development Editor: Sharon Balbos
Consultant: Ryan Herzog
Executive Media Editor: Rachel Comerford
Media Editor: Lukia Kliossis
Editorial Assistant: Carlos Marin
Director of Editing, Design, and Media Production:
Tracey Kuehn
Managing Editor: Lisa Kinne
Project Editor: Jeanine Furino
Senior Design Manager: Vicki Tomaselli
Cover Design: Brian Sheridan, Hothouse Designs, Inc.
Illustrations: TSI evolve, Network Graphics
Illustration Coordinator: Janice Donnola
Photo Editor: Cecilia Varas
Photo Researcher: Elyse Rieder
Production Managers: Barbara Anne Seixas,
Stacey Alexander
Supplements Project Editor: Edgar Bonilla
Composition: TSI evolve
Printing and Binding: RR Donnelley
ISBN-13: 978-1-4641-1037-5
ISBN-10: 1-4641-1037-9
Library of Congress Control Number: 2015930274
© 2015, 2013, 2009, 2006 by Worth Publishers
All rights reserved.
Printed in the United States of America
First printing
Worth Publishers
41 Madison Avenue
New York, NY 10010
www.worthpublishers.com
To beginning students everywhere,
which we all were at one time.
this page left intentionally blank
Author__Krugman/Wells___ Title _Economics 4e____ Perm. Fig.# __P001_ New Fig.# _ PUN01 Old Fig.# __________ L/LC/TS/CP/B&W/CAR N/PU/PUAC ABOUT THE AUTHORS
Paul Krugman, recipient of the 2008 Nobel
Memorial Prize in Economic Sciences, taught at
Princeton University for 14 years and, as of June
2015, he will have joined the faculty of the Graduate Center of the City University of New York. In
his new position, he is associated with the Luxembourg Income Study, which tracks and analyzes
income inequality around the world. He received
his BA from Yale and his PhD from MIT. Before
Princeton, he taught at Yale, Stanford, and MIT.
He also spent a year on the staff of the Council of
Economic Advisers in 1982–1983. His research has
included pathbreaking work on international trade,
economic geography, and currency crises. In 1991,
[No caption] Ligaya Franklin
Krugman received the American Economic Association’s
John Bates Clark
medal. In addition to his teaching and academic research, Krugman writes
extensively for nontechnical audiences. He is a regular op-ed columnist for
1 the New York Times. His best-selling trade books include End This Depression
Now!, The Return of Depression Economics and the Crisis of 2008, a history of
recent economic troubles and their implications for economic policy, and The
Conscience of a Liberal, a study of the political economy of economic inequality and its relationship with political polarization from the Gilded Age to the
present. His earlier books, Peddling Prosperity and The Age of Diminished
Expectations, have become modern classics.
Robin Wells was a Lecturer and Researcher in Economics at Princeton
University. She received her BA from the University of Chicago and her PhD from
the University of California at Berkeley; she then did postdoctoral work at MIT.
She has taught at the University of Michigan, the University of Southampton
(United Kingdom), Stanford, and MIT.
vii
BRIEF CONTENTS
Preface xvii
PART
1
PART
What Is Economics?
The Ordinary Business of Life 1
Chapter 1
First Principles 5
Chapter 2Economic Models: Trade-offs
and Trade 25
Appendix
Graphs in Economics 51
Introduction
PART
2
Supply and Demand
Chapter 3
Supply and Demand 67
Chapter 4Price Controls and Quotas: Meddling
with Markets 103
Chapter 5International Trade 131
Appendix
Consumer and Producer Surplus 163
PART
3Introduction to
Macroeconomics
Chapter 6
Macroeconomics: The Big Picture 169
Chapter 7GDP and the CPI: Tracking the
Macroeconomy 191
Chapter 8
Unemployment and Inflation 217
PART
4
Chapter 9
Chapter 10
Long-Run Economic Growth
Long-Run Economic Growth 245
Savings, Investment Spending, and
the Financial System 279
AppendixToward a Fuller Understanding of
Present Value 313
viii
5Short-Run Economic
Fluctuations
Chapter 11
Appendix
Income and Expenditure 317
Deriving the Multiplier Algebraically 347
Chapter 12
Aggregate Demand and Aggregate
Supply 349
PART
6
Chapter 13
Appendix
Stabilization Policy
Fiscal Policy 385
Taxes and the Multiplier 417
Chapter 14
Money, Banking, and the Federal Reserve
Chapter 15
System 419
Monetary Policy 455
Appendix
econciling the Two Models of the Interest
R
Rate 481
Chapter 16
Inflation, Disinflation, and Deflation 485
Crises and Consequences 513
Chapter 17
PART
7
Chapter 18
PART
8
Chapter 19
Events and Ideas
Macroeconomics: Events and Ideas 539
The Open Economy
Open-Economy Macroeconomics 563
Macroeconomic Data Tables M-1
Solutions to “Check Your Understanding” Questions S-1
Glossary G-1
Index I-1
CONTENTS
Preface xvii
PART
1 What Is Economics?
u INTRODUCTION The Ordinary
Business of Life......................... 1
ANY GIVEN SUNDAY
1
The Invisible Hand 2
ECONOMICS ➤ IN ACTION Adventures in Babysitting 20
BUSINESS CAS E: H
ow Priceline.com Revolutionized the Travel
Industry 21
u CHAPTER 2 Economics Models:
My Benefit, Your Cost 3
Good Times, Bad Times 3
Trade-offs and Trade................. 25
25
Models in Economics: Some Important Examples 26
FOR INQUIRING MINDS: The Model That Ate the Economy 26
Trade-offs: The Production Possibility Frontier 27
Comparative Advantage and Gains from Trade 33
FROM KITTY HAWK TO DREAMLINER
Onward and Upward 4
An Engine for Discovery 4
u CHAPTER 1
Principle #11: Overall Spending Sometimes Gets Out
of Line with the Economy’s Productive Capacity 19
Principle #12: Government Policies Can Change
Spending 19
First Principles.................................5
5
Principles That Underlie Individual Choice:
The Core of Economics 6
COMMON GROUND
Principle #1: Choices Are Necessary Because
Resources Are Scarce 6
Principle #2: The True Cost of Something Is Its
Opportunity Cost 7
Principle #3: “How Much” Is a Decision at
the Margin 8
Principle #4: People Usually Respond to
Incentives, Exploiting Opportunities to Make
Themselves Better Off 9
FOR INQUIRING MINDS: Cashing In at School 10
ECONOMICS ➤ IN ACTION Boy or Girl? It Depends
on the Cost 10
Interaction: How Economies Work 12
Principle #5: There Are Gains from Trade 12
Principle #6: Markets Move Toward Equilibrium 13
FOR INQUIRING MINDS: Choosing Sides 14
Principle #7: Resources Should Be Used Efficiently to
Achieve Society’s Goals 15
Principle #8: Markets Usually Lead to Efficiency 16
Principle #9: When Markets Don’t Achieve Efficiency,
Government Intervention Can Improve Society’s
Welfare 16
ECONOMICS ➤ IN ACTION Restoring Equilibrium on
the Freeways 17
Economy-Wide Interactions 18
Principle #10: One Person’s Spending Is Another
Person’s Income 18
Comparative Advantage and International Trade,
in Reality 36
GLOBAL COMPARISON: Pajama Republics 37
Transactions: The Circular-Flow Diagram 37
ECONOMICS ➤ IN ACTION Rich Nation, Poor Nation 39
Using Models 40
Positive versus Normative Economics 40
When and Why Economists Disagree 41
FOR INQUIRING MINDS: When Economists Agree
42
ECONOMICS ➤ IN ACTION Economists, Beyond the
Ivory Tower 43
BUSINESS CAS E: E
fficiency, Opportunity Cost, and
the Logic of Lean Production 45
Graphs in
Economics................................ 51
CHAPTER 2 APPENDIX Getting the Picture 51
Graphs, Variables, and Economic Models 51
How Graphs Work 51
Two-Variable Graphs 51
Curves on a Graph 53
A Key Concept: The Slope of a Curve 54
The Slope of a Linear Curve 54
Horizontal and Vertical Curves and Their Slopes 55
The Slope of a Nonlinear Curve 56
Calculating the Slope Along a Nonlinear Curve 56
Maximum and Minimum Points 58
ix
x
CONTENTS
Calculating the Area Below or Above a Curve 59
Graphs That Depict Numerical Information 60
Types of Numerical Graphs 60
Problems in Interpreting Numerical Graphs 62
PART
2 Supply and Demand
u CHAPTER 3
Supply and Demand.................. 67
Price Ceilings 104
Modeling a Price Ceiling 105
How a Price Ceiling Causes Inefficiency 106
FOR INQUIRING MINDS: M
umbai’s Rent-Control
Millionaires 109
So Why Are There Price Ceilings? 110
ECONOMICS ➤ IN ACTION Price Controls in Venezuela:
“You Buy What They Have” 110
Price Floors 111
How a Price Floor Causes Inefficiency 113
67
Supply and Demand: A Model of a Competitive
Market 68
GLOBAL COMPARISON: Check Out Our Low, Low Wages! 116
The Demand Curve 69
ECONOMICS ➤ IN ACTION The Rise and Fall of the Unpaid
Intern 116
A NATURAL GAS BOOM
The Demand Schedule and the Demand Curve 69
Shifts of the Demand Curve 70
GLOBAL COMPARISON: Pay More, Pump Less 71
Understanding Shifts of the Demand Curve 73
ECONOMICS ➤ IN ACTION Beating the Traffic 78
The Supply Curve 79
The Supply Schedule and the Supply Curve 79
Shifts of the Supply Curve 80
Understanding Shifts of the Supply Curve 81
ECONOMICS ➤ IN ACTION Only Creatures Small
and Pampered 85
Supply, Demand, and Equilibrium 86
Finding the Equilibrium Price and Quantity 86
Why Do All Sales and Purchases in a Market
Take Place at the Same Price? 87
Why Does the Market Price Fall If It Is Above
the Equilibrium Price? 88
Why Does the Market Price Rise If It Is Below
the Equilibrium Price? 88
Using Equilibrium to Describe Markets 89
ECONOMICS ➤ IN ACTION The Price of Admission 89
Changes in Supply and Demand 90
What Happens When the Demand Curve Shifts 91
What Happens When the Supply Curve Shifts 92
Simultaneous Shifts of Supply and Demand Curves 93
FOR INQUIRING MINDS: Tribulations on the Runway 94
ECONOMICS ➤ IN ACTION The Cotton Panic and
Crash of 2011 95
So Why Are There Price Floors? 116
Controlling Quantities 118
The Anatomy of Quantity Controls 118
The Costs of Quantity Controls 121
ECONOMICS ➤ IN ACTION Crabbing, Quotas, and
Saving Lives in Alaska 122
BUSINESS CAS E: M
edallion Financial: Cruising
Right Along 124
u CHAPTER 5
International Trade.................... 131
THE EVERYWHERE PHONE 131
Comparative Advantage and International Trade 132
Production Possibilities and Comparative
Advantage, Revisited 133
The Gains from International Trade 135
Comparative Advantage versus Absolute
Advantage 136
GLOBAL COMPARISON: Productivity and Wages Around
the World 137
Sources of Comparative Advantage 138
FOR INQUIRING MINDS: Increasing Returns to Scale and
International Trade 140
ECONOMICS ➤ IN ACTION How Hong Kong Lost
Its Shirts 140
Supply, Demand, and International Trade 141
The Effects of Imports 142
The Effects of Exports 144
International Trade and Wages 146
Competitive Markets—And Others 96
ECONOMICS ➤ IN ACTION Trade, Wages, and Land Prices
in the Nineteenth Century 147
BUSINESS CAS E: A
n Uber Way to Get a Ride 97
The Effects of Trade Protection 148
u CHAPTER 4 Price Controls and
Quotas: Meddling with
Markets.................................................... 103
103
Why Governments Control Prices 104
BIG CITY, NOT-SO-BRIGHT IDEAS
The Effects of a Tariff 148
The Effects of an Import Quota 150
ECONOMICS ➤ IN ACTION Trade Protection in the United
States 151
The Political Economy of Trade Protection 152
Arguments for Trade Protection 152
CONTENTS
The Politics of Trade Protection 152
International Trade Agreements and the World Trade
Organization 153
FOR INQUIRING MINDS: Tires Under Pressure 154
Challenges to Globalization 154
ECONOMICS ➤ IN ACTION Beefing Up Exports 156
BUSINESS CAS E: L
i & Fung: From Guangzhou to You 158
Consumer and
Producer Surplus............. 163
CHAPTER 5 APPENDIX Consumer Surplus and the Demand Curve 163
Willingness to Pay and the Demand Curve 163
Willingness to Pay and Consumer Surplus 164
Producer Surplus and the Supply Curve 165
Cost and Producer Surplus 165
The Gains from Trade 167
PART
3 Introduction to
Macroeconomics
u CHAPTER 6 Macroeconomics:
The Big Picture........................... 169
THE PAIN IN SPAIN 169
The Nature of Macroeconomics 170
Macroeconomic Questions 170
Macroeconomics: The Whole Is Greater Than the Sum
of Its Parts 171
Macroeconomics: Theory and Policy 171
ECONOMICS ➤ IN ACTION Fending Off Depression 172
The Business Cycle 173
Charting the Business Cycle 174
The Pain of Recession 175
FOR INQUIRING MINDS: Defining Recessions and
Expansions 176
Taming the Business Cycle 177
GLOBAL COMPARISON: Slumps Across the Atlantic 177
ECONOMICS ➤ IN ACTION Comparing Recessions 178
Long-Run Economic Growth 178
International Imbalances 183
ECONOMICS ➤ IN ACTION Spain’s Costly Surplus 184
BUSINESS CAS E: T
he Business Cycle and the Decline of
Montgomery Ward 186
u CHAPTER 7 GDP and the CPI: Tracking
the Macroeconomy................ 191
THE NEW #2 191
The National Accounts 192
The Circular-Flow Diagram, Revisited and
Expanded 192
Gross Domestic Product 195
Calculating GDP 196
FOR INQUIRING MINDS: O
ur Imputed Lives 197
FOR INQUIRING MINDS: G
ross What? 200
What GDP Tells Us 201
ECONOMICS ➤ IN ACTION Creating the National
Accounts 201
Real GDP: A Measure of Aggregate Output 202
Calculating Real GDP 202
What Real GDP Doesn’t Measure 203
GLOBAL COMPARISON: GDP and the Meaning of Life 204
ECONOMICS ➤ IN ACTION Miracle in Venezuela? 205
Price Indexes and the Aggregate Price Level 205
Market Baskets and Price Indexes 206
The Consumer Price Index 207
Other Price Measures 208
ECONOMICS ➤ IN ACTION Indexing to the CPI 209
BUSINESS CAS E: G
etting a Jump on GDP 211
u CHAPTER 8 Unemployment
and Inflation.................................... 217
HITTING THE BRAKING POINT 217
The Unemployment Rate 218
Defining and Measuring Unemployment 218
The Significance of the Unemployment Rate 219
Growth and Unemployment 221
ECONOMICS ➤ IN ACTION Failure to Launch 223
The Natural Rate of Unemployment 224
The Causes of Inflation and Deflation 181
The Pain of Inflation and Deflation 182
Job Creation and Job Destruction 224
Frictional Unemployment 225
Structural Unemployment 227
The Natural Rate of Unemployment 229
GLOBAL COMPARISON: Natural Unemployment Around the
OECD 230
Changes in the Natural Rate of Unemployment 230
ECONOMICS ➤ IN ACTION A Fast (Food) Measure of
Inflation 182
ECONOMICS ➤ IN ACTION Structural Unemployment in
East Germany 232
FOR INQUIRING MINDS: When Did Long-Run Growth
Start? 180
ECONOMICS ➤ IN ACTION A Tale of Two Countries 180
Inflation and Deflation 181
xi
xii
CONTENTS
Inflation and Deflation 233
The Level of Prices Doesn’t Matter . . . 233
. . . But the Rate of Change of Prices Does 234
Winners and Losers from Inflation 237
Inflation Is Easy; Disinflation Is Hard 238
ECONOMICS ➤ IN ACTION Israel’s Experience with
Inflation 239
BUSINESS CAS E: Day Labor in the Information Age 240
PART
4 Long-Run Economic Growth
u CHAPTER 9 Long-Run Economic Growth
245
AIRPOCALYPSE NOW 245
Comparing Economies Across Time and Space 246
Real GDP per Capita 246
Growth Rates 248
u CHAPTER 10 Savings, Investment
Spending, and the
Financial System................... 279
FUNDS FOR FACEBOOK 279
Matching Up Savings and Investment Spending 280
The Savings–Investment Spending Identity 280
FOR INQUIRING MINDS: W
ho Enforces the Accounting? 283
The Market for Loanable Funds 284
FOR INQUIRING MINDS: Using Present Value 285
ECONOMICS ➤ IN ACTION Sixty Years of U.S. Interest
Rates 292
The Financial System 293
Three Tasks of a Financial System 294
Types of Financial Assets 296
Financial Intermediaries 297
GLOBAL COMPARISON: Bonds Versus Banks 299
ECONOMICS ➤ IN ACTION India Takes Off 249
ECONOMICS ➤ IN ACTION Banks and the South Korean
Miracle 300
The Sources of Long-Run Growth 250
Financial Fluctuations 301
The Crucial Importance of Productivity 250
Explaining Growth in Productivity 251
Accounting for Growth: The Aggregate Production
Function 251
What About Natural Resources? 255
ECONOMICS ➤ IN ACTION Is the End of Economic Growth
in Sight? 256
Why Growth Rates Differ 257
Explaining Differences in Growth Rates 258
FOR INQUIRING MINDS: Inventing R&D 259
GLOBAL COMPARISON: What’s the Matter with Italy? 260
The Role of Government in Promoting Economic
Growth 260
FOR INQUIRING MINDS: T
he New Growth Theory 261
The Demand for Stocks 301
FOR INQUIRING MINDS: How Now, Dow Jones? 302
The Demand for Other Assets 303
Asset Price Expectations 303
FOR INQUIRING MINDS: Behavioral Finance 304
Asset Prices and Macroeconomics 305
ECONOMICS ➤ IN ACTION The Great American Housing
Bubble 306
BUSINESS CAS E: G
rameen Bank: Banking Against
Poverty 308
Toward a Fuller
Understanding
of Present Value.............. 313
CHAPTER 10 APPENDIX ECONOMICS ➤ IN ACTION Why Did Britain Fall
Behind? 262
How to Calculate the Present Value of One-Year
Projects 313
Success, Disappointment, and Failure 263
How to Calculate the Present Value of Multiyear
Projects 313
East Asia’s Miracle 264
Latin America’s Disappointment 265
Africa’s Troubles and Promise 265
ECONOMICS ➤ IN ACTION Are Economies
Converging? 266
Is World Growth Sustainable? 268
Natural Resources and Growth, Revisited 268
Economic Growth and the Environment 270
ECONOMICS ➤ IN ACTION The Cost of Limiting
Carbon 272
BUSINESS CAS E: H
ow Boeing Got Better 274
How to Calculate the Present Value of Projects with
Revenues and Costs 314
How to Calculate the Price of a Bond Using Present
Value 315
How to Calculate the Price of a Share of Stock Using
Present Value 316
CONTENTS
PART
5 Short-Run Economic
Fluctuations
u CHAPTER 11 Income and
Expenditure................................. 317
FROM BOOM TO BUST 317
The Multiplier: An Informal Introduction 318
ECONOMICS ➤ IN ACTION Sand State Slump 320
Consumer Spending 321
Current Disposable Income and Consumer
Spending 321
Shifts of the Aggregate Consumption Function 324
ECONOMICS ➤ IN ACTION Famous First Forecasting
Failures 326
Investment Spending 327
The Interest Rate and Investment Spending 328
Expected Future Real GDP, Production Capacity, and
Investment Spending 329
Inventories and Unplanned Investment Spending 330
ECONOMICS ➤ IN ACTION Interest Rates and the U.S.
Housing Boom 331
The Income–Expenditure Model 332
Planned Aggregate Spending and Real GDP 333
Income–Expenditure Equilibrium 334
The Multiplier Process and Inventory Adjustment 336
ECONOMICS ➤ IN ACTION Inventories and the End of a
Recession 339
BUSINESS CAS E: W
hat’s Good for America Is Good for
GM 341
Deriving the Multiplier
Algebraically......................... 347
CHAPTER 11 APPENDIX u CHAPTER 12 Aggregate Demand and
Aggregate Supply................ 349
WHAT KIND OF SHOCK? 349
Aggregate Demand 350
Why Is the Aggregate Demand Curve Downward
Sloping? 351
The Aggregate Demand Curve and the
Income–Expenditure Model 352
Shifts of the Aggregate Demand Curve 354
Government Policies and Aggregate Demand 357
ECONOMICS ➤ IN ACTION Moving Along the
Aggregate Demand Curve,
1979–1980 358
Aggregate Supply 358
The Short-Run Aggregate Supply Curve 359
xiii
FOR INQUIRING MINDS: W
hat’s Truly Flexible, What’s Truly
Sticky 360
Shifts of the Short-Run Aggregate Supply Curve 361
The Long-Run Aggregate Supply Curve 364
From the Short Run to the Long Run 366
ECONOMICS ➤ IN ACTION Sticky Wages in the Great
Recession 367
The AD–AS Model 368
Short-Run Macroeconomic Equilibrium 368
Shifts of Aggregate Demand: Short-Run Effects 369
Shifts of the SRAS Curve 370
GLOBAL COMPARISON: Supply Shocks of the Twenty-first
Century 372
Long-Run Macroeconomic Equilibrium 372
FOR INQUIRING MINDS: W
here’s the Deflation? 375
ECONOMICS ➤ IN ACTION Supply Shocks Versus Demand
Shocks in Practice 375
Macroeconomic Policy 376
FOR INQUIRING MINDS: K
eynes and the Long Run 377
Policy in the Face of Demand Shocks 377
Responding to Supply Shocks 378
ECONOMICS ➤ IN ACTION Is Stabilization Policy
Stabilizing? 378
BUSINESS CAS E: S
low Steaming 380
PART
6 Stabilization Policy
u CHAPTER 13 Fiscal Policy................................ 385
HOW BIG IS BIG ENOUGH? 385
Fiscal Policy: The Basics 386
Taxes, Purchases of Goods and Services, Government
Transfers, and Borrowing 386
The Government Budget and Total Spending 387
Expansionary and Contractionary Fiscal Policy 388
Can Expansionary Fiscal Policy Actually Work? 390
A Cautionary Note: Lags in Fiscal Policy 391
ECONOMICS ➤ IN ACTION What Was in the Recovery
Act? 392
Fiscal Policy and the Multiplier 393
Multiplier Effects of an Increase in Government
Purchases of Goods and Services 393
Multiplier Effects of Changes in Government Transfers
and Taxes 394
How Taxes Affect the Multiplier 395
ECONOMICS ➤ IN ACTION Austerity and the Multiplier 396
The Budget Balance 397
The Budget Balance as a Measure of Fiscal Policy 398
The Business Cycle and the Cyclically Adjusted Budget
Balance 398
Should the Budget Be Balanced? 401
xiv
CONTENTS
ECONOMICS ➤ IN ACTION Europe’s Search for a Fiscal
Rule 401
ECONOMICS ➤ IN ACTION The Fed’s Balance Sheet,
Normal and Abnormal 440
Long-Run Implications of Fiscal Policy 402
The Evolution of the American Banking System 441
Deficits, Surpluses, and Debt 403
The Crisis in American Banking in the Early Twentieth
Century 441
GLOBAL COMPARISON: The American Way of Debt 404
Problems Posed by Rising Government Debt 405
Deficits and Debt in Practice 406
FOR INQUIRING MINDS: W
hat Happened to the Debt from World
War II? 407
Implicit Liabilities 407
ECONOMICS ➤ IN ACTION Are We Greece? 409
BUSINESS CAS E: H
ere Comes the Sun 411
CHAPTER 13 APPENDIX
axes and the
T
Multiplier....................................417
u CHAPTER 14 Money, Banking, and
the Federal Reserve
System................................................419
FUNNY MONEY 419
The Meaning of Money 420
What Is Money? 420
Roles of Money 421
GLOBAL COMPARISON: The Big Moneys 421
Types of Money 422
Measuring the Money Supply 423
FOR INQUIRING MINDS: W
hat’s with All the Currency? 424
ECONOMICS ➤ IN ACTION The History of the Dollar 425
The Monetary Role of Banks 426
What Banks Do 426
The Problem of Bank Runs 427
Bank Regulation 428
ECONOMICS ➤ IN ACTION It’s a Wonderful Banking
System 429
Determining the Money Supply 430
How Banks Create Money 430
Reserves, Bank Deposits, and the Money
Multiplier 432
The Money Multiplier in Reality 433
ECONOMICS ➤ IN ACTION Multiplying Money Down 434
The Federal Reserve System 435
The Structure of the Fed 435
What the Fed Does: Reserve Requirements and the
Discount Rate 436
Open-Market Operations 437
FOR INQUIRING MINDS: W
ho Gets the Interest on the Fed’s
Assets? 439
The European Central Bank 439
Responding to Banking Crises: The Creation of the
Federal Reserve 442
The Savings and Loan Crisis of the 1980s 444
Back to the Future: The Financial Crisis of 2008 444
ECONOMICS ➤ IN ACTION Regulation After the 2008
Crisis 447
BUSINESS CAS E: The Perfect Gift: Cash or a Gift Card? 449
u CHAPTER 15 Monetary Policy...................... 455
THE MOST POWERFUL PERSON IN GOVERNMENT 455
The Demand for Money 456
The Opportunity Cost of Holding Money 456
The Money Demand Curve 458
Shifts of the Money Demand Curve 459
ECONOMICS ➤ IN ACTION A Yen for Cash 460
Money and Interest Rates 461
The Equilibrium Interest Rate 461
Two Models of Interest Rates? 463
Monetary Policy and the Interest Rate 463
Long-Term Interest Rates 465
ECONOMICS ➤ IN ACTION The Fed Reverses Course 466
Monetary Policy and Aggregate Demand 467
Expansionary and Contractionary Monetary Policy 467
Monetary Policy in Practice 468
The Taylor Rule Method of Setting Monetary Policy 469
Inflation Targeting 469
GLOBAL COMPARISON: Inflation Targets 470
The Zero Lower Bound Problem 471
ECONOMICS ➤ IN ACTION What the Fed Wants, the Fed
Gets 471
Money, Output, and Prices in the Long Run 472
Short-Run and Long-Run Effects of an Increase in the
Money Supply 472
Monetary Neutrality 474
Changes in the Money Supply and the Interest Rate in
the Long Run 474
ECONOMICS ➤ IN ACTION International Evidence of
Monetary Neutrality 475
BUSINESS CAS E: P
IMCO Bets on Cheap Money 477
Reconciling the
Two Models of the
Interest Rate......................... 481
CHAPTER 15 APPENDIX The Interest Rate in the Short Run 481
The Interest Rate in the Long Run 482
CONTENTS
u CHAPTER 16 Inflation, Disinflation,
The Consequences of Banking Crises 523
Banking Crises, Recessions, and Recovery 523
Why Are Banking-Crisis Recessions So Bad? 524
Governments Step In 525
and Deflation............................. 485
BRINGING A SUITCASE TO THE BANK 485
Money and Inflation 486
The Classical Model of Money and Prices 486
The Inflation Tax 488
The Logic of Hyperinflation 489
ECONOMICS ➤ IN ACTION Banks and the Great
Depression 527
The 2008 Crisis and Its Aftermath 528
Severe Crisis, Slow Recovery 528
Aftershocks in Europe 529
The Stimulus–Austerity Debate 531
The Lesson of the Post-Crisis Slump 532
ECONOMICS ➤ IN ACTION Zimbabwe’s Inflation 491
Moderate Inflation and Disinflation 491
The Output Gap and the Unemployment Rate 492
FOR INQUIRING MINDS: O
kun’s Law 494
The Short-Run Phillips Curve 494
FOR INQUIRING MINDS: T
he Aggregate Supply Curve and the
Short-Run Phillips Curve 496
Inflation Expectations and the Short-Run Phillips
Curve 497
ECONOMICS ➤ IN ACTION The Phillips Curve in the Great
Recession 499
Inflation and Unemployment in the Long Run 500
The Long-Run Phillips Curve 500
The Natural Rate of Unemployment, Revisited 502
The Costs of Disinflation 502
GLOBAL COMPARISON: Disinflation Around the World 502
ECONOMICS ➤ IN ACTION The Great Disinflation of the
1980s 503
Deflation 504
Debt Deflation 504
Effects of Expected Deflation 505
ECONOMICS ➤ IN ACTION If Only It Were the 1930s 532
Regulation in the Wake of the Crisis 533
ECONOMICS ➤ IN ACTION Bent Breaks the Buck 534
PART
7 Events and Ideas
u CHAPTER 18 Macroeconomics:
Events and Ideas.................. 539
A TALE OF TWO SLUMPS 539
Classical Macroeconomics 540
Money and the Price Level 540
The Business Cycle 540
ECONOMICS ➤ IN ACTION When Did the Business Cycle
Begin? 540
The Great Depression and the Keynesian
Revolution 541
Keynes’s Theory 542
ECONOMICS ➤ IN ACTION Is Europe Turning
Japanese? 506
BUSINESS CAS E: Licenses to Print Money 508
FOR INQUIRING MINDS: The Politics of Keynes 543
u CHAPTER 17 Crises and
ECONOMICS ➤ IN ACTION The End of the Great
Depression 544
Consequences.........................513
FROM PURVEYOR OF DRY GOODS TO DESTROYER
OF WORLDS 513
Banking: Benefits and Dangers 514
The Trade-off Between Rate of Return and
Liquidity 514
The Purpose of Banking 515
Shadow Banks and the Re-emergence of Bank
Runs 516
ECONOMICS ➤ IN ACTION The Day the Lights Went Out at
Lehman 517
Banking Crises and Financial Panics 518
The Logic of Banking Crises 518
Historical Banking Crises: The Age of Panics 520
Modern Banking Crises Around the World 521
ECONOMICS ➤ IN ACTION Erin Go Broke 522
xv
Policy to Fight Recessions 544
Challenges to Keynesian Economics 545
The Revival of Monetary Policy 545
Monetarism 546
Limits to Macroeconomic Policy: Inflation and the
Natural Rate of Unemployment 549
The Political Business Cycle 549
ECONOMICS ➤ IN ACTION The Fed’s Flirtation with
Monetarism 550
Rational Expectations, Real Business Cycles, and
New Classical Macroeconomics 550
Rational Expectations 551
Real Business Cycles 552
FOR INQUIRING MINDS: S
upply-Side Economics 552
ECONOMICS ➤ IN ACTION The 1970s in Reverse 553
xvi
CONTENTS
Consensus and Conflict in Modern
Macroeconomics 554
Question 1: Is Expansionary Monetary Policy Helpful in
Fighting Recessions? 554
Question 2: Is Expansionary Fiscal Policy Effective in
Fighting Recessions? 555
Question 3: Can Monetary and/or Fiscal Policy Reduce
Unemployment in the Long Run? 555
Question 4: Should Fiscal Policy Be Used in a
Discretionary Way? 555
Question 5: Should Monetary Policy Be Used in a
Discretionary Way? 556
Crises and Aftermath 556
ECONOMICS ➤ IN ACTION Lats of Luck 558
PART
8 The Open Economy
ECONOMICS ➤ IN ACTION The Golden Age of Capital
Flows 572
The Role of the Exchange Rate 573
Understanding Exchange Rates 574
The Equilibrium Exchange Rate 574
Inflation and Real Exchange Rates 577
Purchasing Power Parity 579
FOR INQUIRING MINDS: Burgernomics 579
ECONOMICS ➤ IN ACTION Low-Cost America 580
Exchange Rate Policy 581
Exchange Rate Regimes 582
How Can an Exchange Rate Be Held Fixed? 582
The Exchange Rate Regime Dilemma 584
FOR INQUIRING MINDS: From Bretton Woods to the Euro 584
ECONOMICS ➤ IN ACTION China Pegs the Yuan 585
Exchange Rates and Macroeconomic Policy 586
u CHAPTER 19 Open-Economy
Macroeconomics.................. 563
SWITZERLAND DOESN’T WANT YOUR MONEY 563
Capital Flows and the Balance of Payments 564
Balance of Payments Accounts 564
FOR INQUIRING MINDS: G
DP, GNP, and the Current
Account 566
Modeling the Financial Account 568
GLOBAL COMPARISON: Big Surpluses 569
Underlying Determinants of International Capital
Flows 571
FOR INQUIRING MINDS: A
Global Savings Glut? 571
Two-Way Capital Flows 572
1. Devaluation and Revaluation of Fixed Exchange
Rates 586
2. Monetary Policy Under Floating Exchange
Rates 587
3. International Business Cycles 588
ECONOMICS ➤ IN ACTION The Little Currency That
Could 589
BUSINESS CAS E: A
Yen for Japanese Cars 591
Macroeconomic Data Tables M-1
Solutions to “Check Your Understanding” Questions S-1
Glossary G-1
Index I-1
PREFACE
“Stories are good for us, whether we hear them, read them, write
them, or simply imagine them. But stories that we read are
particularly good for us. In fact I believe they are essential.”
Frank Smith, Reading: FAQ
The Importance of a Narrative
Approach
More than a decade ago, when Robin and I began
writing the first edition of this textbook, we had many
small ideas: particular aspects of economics that we
believed weren’t covered the right way in existing textbooks. But we also had one big idea: the belief that an
economics textbook could and should be built around
narratives, that it should never lose sight of the fact
that economics is, in the end, a set of stories about
what people do.
Many of the stories economists tell take the form of
models—for whatever else they are, economic models
are stories about how the world works. But we believed
that students’ understanding of and appreciation for
models would be greatly enhanced if they were presented, as much as possible, in the context of stories about
the real world, stories that both illustrate economic
concepts and touch on the concerns we all face as individuals living in a world shaped by economic forces.
Those stories have been integrated into every edition,
including this one. Once again, you’ll find them in the
openers, in special features like Economics in Action,
For Inquiring Minds, Global Comparison, and in our
business cases. We have been gratified by the reception this storytelling approach has received and in this
edition of Macroeconomics we continue to expand the
book’s appeal by including many new stories on a broad
range of topics, and by updating and revising others.
Specifically, there are 8 new opening stories, 19 new
Economics in Actions, and 8 new business cases. As
always, a significant number of the features that aren’t
completely new have been revised or updated.
We remain extremely fortunate in our reviewers,
who have put in an immense amount of work helping us to make this book even better. And we are also
deeply thankful to the users who have given us feedback, telling us what works and, even more important,
what doesn’t.
Despite the many changes in this new edition, we’ve
tried to keep the spirit the same. This is a book about
economics as the study of what people do and how they
interact, a study very much informed by real-world
experience.
Macroeconomics in the Fourth
Edition: What’s New?
The first edition of this textbook was published at a time
of calm in the U.S. and world economies. In fact, at the
time (in 2005), many economists believed that the socalled Great Moderation, an era of relative stability that
began in the mid-1980s, would continue indefinitely. We
chose, nonetheless, to put recessions and the policies
governments use to fight them front and center, believing that the business cycle is still the core issue in macroeconomics. And subsequent events have both validated
that decision and provided plenty of material to incorporate in each new edition. And so it is with this edition.
Above all, Robin and I hope that this fourth edition
of Macroeconomics leaves students with the sense that
they have learned a lot about the world they’re living in,
but we also believe that hard times in the world economy
have, perversely, greatly improved our ability to teach
macroeconomics. We can now vividly illustrate that macroeconomics really does make sense of the world and that
it really matters. We hope you share our enthusiasm.
A Thorough Revision Reflecting
Recent Events
The financial crisis of 2008 is slowly receding in the
rearview mirror, but the aftershocks continue to reverberate, and most of the big changes since the third
edition reflect those aftershocks. We have, of course,
updated virtually every data-based figure and table in
the book, but beyond that, we have updated or replaced
xvii
xviii
PR E FAC E
many of the real-world narratives that provide context
for the analytical content, and which we believe make
this book special.
This doesn’t mean that we have torn up the basic
analysis of previous editions. On the contrary, one littleappreciated aspect of world economic developments
since the crisis is how well basic macroeconomic models have worked in tracking, for example, the effects of
fiscal policy and monetary expansion. As a result, we
make extensive use of recent events to illustrate macroeconomic principles and concepts, in a way that wouldn’t
have been possible in a more stable world.
This incorporation of recent developments literally
begins at the start, in the first chapter: Chapter 6,
“Macroeconomics, The Big Picture.” Previously, we began
by depicting mass unemployment in the 1930s; now we
begin with a new chapter-opening story about mass
unemployment in today’s Spain (“The Pain in Spain”).
Depression-type conditions are no longer something that happened long ago; as we show in Chapter 8,
“Unemployment and Inflation,” they’re happening right
now to young Europeans who are a lot like our students. And as we also show, even in America, college
graduates have faced years of tough times and many
students’ families and friends will have experienced
the pain of protracted unemployment firsthand, so we
believe that the analysis has gained extra relevance.
Later on, we use recent data to demonstrate the
validity of a number of key concepts. For example,
macroeconomists talk about sticky wages that may not
fall even in the face of unemployment; as we show in
Chapter 12, “Aggregate Demand and Aggregate Supply,”
in recent years that stickiness has been dramatically
illustrated by a surge in the number of workers whose
wages don’t change at all from year to year. Similarly,
we don’t need to appeal to events decades ago to support
the concept of a short-run trade-off between unemployment and inflation, as we show in Chapter 16, “Inflation,
Disinflation, Deflation.” You can see that trade-off
clearly by looking across advanced countries and seeing
that where unemployment has risen, inflation has fallen
the most.
Another example of how recent events have allowed
us to look at macroeconomic concepts in a new way is
the effect of fiscal policy. This used to be a very difficult topic to teach in a way that seemed real, because
large discretionary changes in government spending
hardly ever happened. That’s no longer true. The U.S.
stimulus program of 2009–2010 gave substance to the
concept of expansionary fiscal policy that we illustrated
in the third edition. But now, in the fourth edition, we
have even more real-world experience. As we discuss
in Chapter 13, “Fiscal Policy,” since 2010 many but
not all countries have imposed drastic fiscal austerity,
and—as we discuss in the new Economics in Action,
“Austerity and the Multiplier”—international comparisons between countries with varying degrees of austerity make the discussion of fiscal impacts much more
concrete and accessible.
Meanwhile, long-run fiscal issues—including concerns about solvency—have also become a lot less
abstract. We see this in another new Economics in
Action: “Are We Greece?”, which nobody would have
considered writing a few years ago.
What about the analysis of crises themselves? We
already had a crisis chapter in the third edition, but
it’s now possible to say much more. Chapter 17, “Crises
and Consequences,” extends the story to cover the many
aftershocks of the 2008 crisis, especially the successive waves of turmoil that have swept Europe. It also
includes a discussion of Dodd-Frank financial reform,
which is now a crucial part of the economic scene and
parts of which are starting to show real results.
And there’s more. For example, when we discuss
open-economy macroeconomics in Chapter 19, we
can illustrate the difference between fixed and floating exchange rates by comparing experiences around
the European periphery, where Iceland and Latvia
have followed dramatically different paths. One new
Economics in Action illustrates how Latvia has taken
on outsize significance in the debate over fiscal policy,
serving as an example of successful austerity (“Lats of
Luck”). Another looks at the advantages that Iceland, a
country with its own currency, has had over euro-using
countries, like Greece, when workers’ wages needed
to be cut during tough economic times (“The Little
Currency That Could”).
A Revision that Extends Beyond PostCrisis Analysis
We don’t want to convey the sense that all the changes in
this edition reflect the aftermath of the financial crisis.
We have also added a lot of new material in Chapter 9
on long-run growth, ranging from the all-too-visible
effects of rapid growth on air quality in Beijing (in the
opening story, “Airpocalypse Now”), to the disturbing
collapse of productivity growth in Italy (in a new Global
Comparison, “What’s the Matter with Italy?”), to the
costs of climate protection (in another new Economics
in Action). Progress in air travel has helped illustrate one
of our favorite themes, the often inconspicuous nature of
progress. Today’s jets look a lot like the jets of the 1960s,
but they’re vastly more efficient as we discuss in the new
Chapter 9 business case, “How Boeing Got Better.”
In this new edition, we pay particular attention
to how changes in technology are transforming the
economic landscape. For example, to illustrate market equilibrium we discuss the rise of Uber (in a new
Chapter 3 business case, “An Uber Way to Get a Ride”).
PR E FAC E
RLD VIE
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W
Similarly, the opening story in Chapter 5 on international trade illustrates how international supply chains
have produced the latest iPhone.
We believe environmental concerns are one of the
most pressing issues today and are a good means of
sparking students’ interest in economics. Chapter 3 on
supply and demand has been changed to focus on the
economic effects of fracking. There we trace the supply
shocks and demand changes that gave rise to investment
in the technology of fracking. Being careful not to take
sides, we trace how the supply changes from fracking have
significantly altered the equilibrium of the natural gas
market. We take this new approach even further in applications throughout. In Chapter 9 on growth, we examine
the financial costs and environmental benefits of limiting
carbon emissions: in a new Economics in Action, “The
Cost of Limiting Carbon,” students learn that with the
right incentives, growth and environmental damage need
not go hand in hand. A new business case in the growth
chapter illustrates how stimulus spending on concentrated
thermal solar power plants has lead to job creation and
environmental benefits (“Here Comes the Sun”).
And as always, we pay great attention to integrating
an international perspective, in our Global Comparison
feature, but also in the many globally oriented applications and stories. All global examples are highlighted
with the following icon:
A listing of opening stories,
Economics in Actions, For Inquiring Minds,
Global Comparisons, and business cases
can be found inside the front cover
and on the facing page.
A New Online Feature: Work It Out
Tutorials
This new feature ties together our textbook and the
accompanying online course materials to offer students
interactive assistance with solving one key problem in
every chapter. Available in
, the new Work It
Out feature includes an online tutorial that guides students through each step of the problem-solving process.
xix
There are also choice-specific feedback and video explanations, providing interactive assistance tailored to each
student’s needs. Students can use the Work It Outs, along
with the other offerings in
, to independently
test their comprehension of concepts, build their math
and graphing skills, and prepare for class and exams.
Scan here for a sample Work It Out
problem.
http://qrs.ly/sg49xiw
Advantages of This Book
Our basic approach to textbook writing is the same as
it was in the first edition:
• Chapters build intuition through realistic examples. In every chapter, we use real-world examples,
stories, applications, and case studies to teach the
core concepts and motivate student learning. The
best way to introduce concepts and reinforce them
is through real-world examples; students simply
relate more easily to them.
• Pedagogical features reinforce learning. We’ve
crafted a genuinely helpful set of features that are
described in the following Walkthrough, “Tools for
Learning.”
• Chapters are accessible and entertaining. We use
a fluid and friendly writing style to make concepts
accessible and, whenever possible, we use examples
that are familiar to students.
• Although easy to understand, the book also prepares students for further coursework. There’s no
need to choose between two unappealing alternatives: a textbook that is “easy to teach” but leaves
major gaps in students’ understanding, or a textbook
that is “hard to teach” but adequately prepares students for future coursework. We offer the best of
both worlds.
xx
Every chapter is structured
around a common set of features
that help students learn while
T O O L S F O R L E A R N I N G W A L K T H Rkeeping
O U G Hthem engaged
PR E FAC E
Every chapter is structured around a common set of features that help students
learn while keeping them engaged.
CHAPTER
Supply and Demand
▲
What You Will Learn
in This Chapter
RLD VIE
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W
3
A NATURAL GAS BOOM
a competitive market is
•andWhat
how it is described by the
supply and demand model
• What the demand curve and the
supply curve are
The difference between
•movements
along a curve and
equilibrium price and equilibrium
quantity
•
In the case of a shortage or
surplus, how price moves the
market back to equilibrium
AP Photo/Andrew Rush
How the supply and demand
•curves
determine a market’s
Spencer Platt/Getty Images
shifts of a curve
The adoption of new drilling technologies lead to cheaper natural gas and vigorous protests.
Chapter OverviewsRESIDENT
offer students
OBAMA GOT A VIVID
P
a helpful preview of the key
concepts
they
illustration
of American
free speech
action while touring upstate New York
will learn about in theinchapter.
on August 23, 2013. The president was
greeted by more than 500 chanting and
sign-toting supporters and opponents.
Why the ruckus? Because upstate New
York is a key battleground over the adoption of a relatively new method of producing energy supplies. Hydraulic fracturing,
or fracking, is a method of extracting
natural gas (and to a lesser extent, oil)
from deposits trapped between layers of
shale rock thousands of feet underground
using—using powerful jets of chemicalladen water to release the gas. While it
has been known for almost a century that
the United States contains vast deposits
of natural gas within these shale formations, they lay untapped because drilling
for them was considered too difficult.
Until recently, that is. A few decades
ago, new drilling technologies were developed that made it possible to reach these
deeply embedded deposits. But what finally pushed energy companies to invest in
and adopt these new extraction technologies was the high price of natural gas over
the last decade. What accounted for these
high natural gas prices—a quadrupling
from 2002 to 2006? There were two principal factors—one reflecting the demand
for natural gas, the other the supply of
natural gas.
First, the demand side. In 2002, the
U.S. economy was mired in recession;
with economic activity low and job losses
high, people and businesses cut back
their energy consumption. For example,
to save money, homeowners turned down
their thermostats in winter and turned
them up in the summer. But by 2006, the
U.S. economy came roaring back, and
natural gas consumption rose. Second,
the supply side. In 2005, Hurricane
Katrina devastated the American Gulf
Coast, site of most of the country’s natural gas production at the time. So by 2006
the demand for natural gas had surged
while the supply of natural gas had been
severely curtailed. As a result, in 2006
natural gas prices peaked at around $14
per thousand cubic feet, up from around
$2 in 2002.
Fast-forward to 2013: natural gas prices once again fell to $2 per thousand
cubic feet. But this time it wasn’t a slow
economy that was the principal explanation, it was the use of the new technologies. “Boom,” “supply shock,” and
Opening Stories Each chapter begins with a compelling
story that is often integrated throughout the rest of the chapter.
Many of the stories in this edition are new, including the one
shown here.
KrugWellsEC4e_Micro_CH03.indd 67
xx
“game changer” was how energy experts
described the impact of these technologies on oil and natural gas production and prices. To illustrate, the United
States produced 8.13 trillion cubic feet of
natural gas from shale deposits in 2012,
nearly doubling the total from 2010. That
total increased again in 2013, to 9.35 trillion cubic feet of natural gas, making the
U.S. the world’s largest producer of both
oil and natural gas—overtaking both
Russia and Saudia Arabia.
The benefits of much lower natural gas
prices have not only led to lower heating costs for American consumers, they
have also cascaded through American
industries, particularly power generation
and transportation. Electricity-generating
power plants are switching from coal to
natural gas, and mass-transit vehicles are
switching from gasoline to natural gas. (You
can even buy an inexpensive kit to convert
your car from gasoline to natural gas.) The
effect has been so significant that many
European manufacturers, paying four times
more for gas than their U.S. rivals, have
been forced to relocate plants to American
soil to survive. In addition, the revived U.S.
natural gas industry has directly created
tens of thousands of new jobs.
67
9/23/14 9:33 AM
xxi
PR E FAC E
TOOLS FOR LEARNING WALK THROUGH
Economics in Action
Global Warming Images/Alamy
A
C
Cities
can reduce traffic congestion
by raising the price of driving.
Quick Review
• The supply and demand
model is a model of a competitive
market—one in which there are
many buyers and sellers of the
same good or service.
• The demand schedule shows
how the quantity demanded
changes as the price changes. A
demand curve illustrates this
relationship.
• The law of demand asserts
that a higher price reduces the
quantity demanded. Thus, demand
curves normally slope downward.
• An increase in demand leads to
a rightward shift of the demand
curve: the quantity demanded rises
for any given price. A decrease in
demand leads to a leftward shift:
the quantity demanded falls for
any given price. A change in price
results in a change in the quantity
demanded and a movement along
the demand curve.
• The five main factors that
can shift the demand curve are
changes in (1) the price of a related
good, such as a substitute or
a complement, (2) income, (3)
tastes, (4) expectations, and (5) the
number of consumers.
W
in Action
RLD VIE
O
W
▲
cases conclude every major
78
PA R T 2
S U P P LY A N D D E M A N D
text section. This much-lauded
feature lets students immediately
ECONOMICS
apply concepts they’ve read
about to real phenomena.
Beating the Traffic
ll big cities have traffic problems, and many local authorities try to discourage driving in the crowded city center. If we think of an auto trip to
the city center as a good that people consume, we can use the identify
economics
which
of demand to analyze anti-traffic policies.
boxes, cases, and applications
are
identify
which
One common strategy is to reduce the demand for auto trips by lowering the
global
in
focus.
boxes,
cases,
and
prices of substitutes. Many metropolitan areas subsidize bus and rail service,
hoping to lure commuters out of their cars. An alternative is to raise the
price of
applications
are
complements: several major U.S. cities impose high taxes on commercial parking
global in focus.
garages and impose short time limits on parking meters, both to raise revenue
and to discourage people from driving into the city.
A few major cities—including Singapore, London, Oslo, Stockholm, and
Milan—have been willing to adopt a direct and politically controversial approach:
reducing congestion by raising the price of driving. Under “congestion pricing”
(or “congestion charging” in the United Kingdom), a charge is imposed on cars
entering the city center during business hours. Drivers buy passes, which are then
debited electronically as they drive by monitoring stations. Compliance is monitored with automatic cameras that photograph license plates.
In 2012, Moscow adopted a modest charge for parking in certain areas in an
attempt to reduce its traffic jams, considered the worst of all major cities. After
the approximately $1.60 charge was applied, city officials estimated that Moscow
traffic decreased by 4%.
The current daily cost of driving in London ranges from £9 to £12 (about $14
to $19). And drivers who don’t pay and are caught pay a fine of £120 (about $192)
for each transgression.
Not surprisingly, studies have shown that after the implementation of congestion pricing, traffic does indeed decrease. In the 1990s, London had some of the
worst traffic in Europe. The introduction of its congestion charge in 2003 immediately reduced traffic in the city center by about 15%, with overall traffic falling
by 21% between 2002 and 2006. And there has been increased use of substitutes,
such as public transportation, bicycles, motorbikes, and ride-sharing. From 2001
to 2011, bike trips in London increased by 79%, and bus usage was up by 30%.
In the United States, the U.S. Department of Transportation has implemented
pilot programs to study congestion pricing. For example, in 2012 Los Angeles
County imposed a congestion charge on an 11-mile stretch of highway in central
Los Angeles. Drivers pay up to $1.40 per mile, the amount depending upon traffic
congestion, with a money-back guarantee that their average speed will never drop
below 45 miles per hour. While some drivers were understandably annoyed at the
charge, others were more philosophical. One driver felt that the toll was a fair price
to escape what often turned into a crawling 45-minute drive, saying, “It’s worth it if
you’re in a hurry to get home. You got to pay the price. If not, get stuck inquestions
traffic.”
allow
Global Stamps Global Stamps
Check Your
Understanding
students to
immediately test
their understanding
1. Explain whether each of the following events represents (i) a shift of the demand
of a section.
curve or (ii) a movement along the demand curve.
a. A store owner finds that customers are willing to pay more for umbrellas on
Solutions appear
rainy days.
at the
back of the
b. When Circus Cruise Lines offered reduced prices for summer cruises
in the
Caribbean, their number of bookings increased sharply.
book.
Check Your Understanding
• The market demand curve is the
horizontal sum of the individual
demand curves of all consumers
in the market.
Quick Reviews offer students a short,
3-1
c. People buy more long-stem roses the week of Valentine’s Day, even though the
prices are higher than at other times during the year.
d. A sharp rise in the price of gasoline leads many commuters to join carpools in
order to reduce their gasoline purchases.
Solutions appear at back of book.
bulleted summary of key concepts in the
section to aid understanding.
KrugWellsEC4e_Micro_CH03.indd 78
9/23/14 9:33 AM
xxi
CHAPTER 3
xxii
PR E FAC E
Demand Schedules for Natural Gas
TOOLS FOR LEARNING WALK THROUGH
$4.00
S U P P LY A N D D E M A N D
3.50
Tribulations on the Runway
Quantity of natural
gas demanded
(trillions of BTUs)
Price of
natural gas
(per BTU)
$4.00
3.75
3.50
3.25
3.00
2.75
2.50
Demand curve
in 2006
RLD VIE
O
W
FOR INQUIRING MINDS
3.75
W
PA R T 2
71
An Increase in Demand
FIGURE 3-2
Price of
natural gas
(per BTU)
94
S U P P LY A N D D E M A N D
in 2002
7.1
7.5
8.1
8.9
10.0
11.5
14.2
in 2006
8.5
9.0
9.7
10.7
12.0
13.8
17.0
For Inquiring Minds
3.25
by a rightward shift of the supply curve
You probably don’t spend much time worin the market for fashion models, which
rying about the trials and tribulations of
3.00
would by itself tend to lower the price
fashion models. Most of them don’t lead
paid to models.
glamorous lives; in fact, except for a lucky
2.75
few, life as a fashion model today can be
Demand curve And that wasn’t the only change in
the market. Unfortunately
for D
Bianca
very trying and not very lucrative. And it’s
2.50
in 2002
D1
2
and others like her, the tastes of many
all because of supply and demand.
of those who hire models have changed
Consider the case of Bianca Gomez,
0
7
9 as well.
11 Fashion
13 magazines
15
17
have come
a willowy 18-year-old from Los Angeles,
Quantity
of natural
gas
to prefer using
celebrities
such
as
with green eyes, honey-colored hair, and
(trillions
BTUs)
Beyoncé on their
pages of
rather
than
flawless skin, whose experience was
anonymous models, believing that their
detailed in a Wall Street Journal article.
readers connect better with a familiar
Bianca began modeling while still in high
A strong economy is one factor that increases the demand for natural gas—a rise in the quantity demanded at any given
face. This amounts to a leftward shift
school, earning about $30,000 in modprice. This is represented by the two demand schedules—one showing the demand in 2002 when the economy was weak,
of the demand curve for models—again
eling fees during her senior year. Having
the other showing the demand in 2006, when the economy was strong—and their corresponding demand curves. The
reducing the equilibrium price paid to
attracted the interest of some top
increase in demand shifts the demand curve to the right.
them.
designers in New York, she moved there
This was borne out in Bianca’s
after graduation, hoping to land jobs
experiences. After paying her rent,
in leading fashion houses and photoher transportation, all her modeling
shoots for leading fashion magazines.
schedule for 2006. It differs from the 2002 schedule because of the stronger U.S.
expenses, and 20% of her earnings to
But once in New York, Bianca
economy,
leading
to
an
increase
in the quantity
of natural
gas demanded at any
her modeling
agency (which
markets
entered the global market for fashion
given price. So at each price the
scheduleclients
showsand
a larger
quantity demanded
her2006
to prospective
books her
models. And it wasn’t very pretty. Due
schedule.
example,
quantity
of natural
Biancathe
found
that she was
barely gas consumers
to the
ease ofP transmitting
92
ART 2
Sphotos
U P P LYelecAND DEM
A Nglobal
Dl b l than
The
Th
market
k tthe
ffor fashion
f 2002
hi models
d l is
i nott For jobs),
breaking even. Sometimes she even had
tronically and the relatively low cost of
at all pretty.
to dip into savings from her high school
international travel, top fashion centers
years. To
money, in
shedemand:
ate macaroni
such as New York and Milan, Italy, are
ly numerous,
some hail from
such responds
To summarize
howplaces
a market
tosave
a change
An increase in
G
L
O
B
A
L
and hot dogs;
sheand
traveled
to auditions, quantity. A
deluged each year with thousands of
asdemand
Kazakhstan
andtoMozambique.
leads
a COMPARISION
rise in both the equilibrium
price
the equilibrium
Pay
More,
Pump
Less
often four or five in one day, by subway.
beautiful young women from all over the
Returning to our (less glamorous)
decrease in demand leads to a fall in both the equilibrium price and the equilibrium
As the Wall Street Journal reported,
world, eagerly trying to make it as modeconomic model of supply and demand,
quantity.
or fashion
a real-world
of the was
law seriously
of demand,
con- quitBianca
considering
els. Although Russians, other Eastern
the
influx of aspiring
modelsillustration
from
Price of
siderbehow
gasoline consumption
varies according
ting modeling
altogether. to the
Europeans, and Brazilians are particulararound the world can
represented
gasoline
prices consumers pay at the pump. Because of high taxes,
United Kingdom
What Happens
When the Supply Curve Shifts (per gallon)
Italy
gasoline and diesel fuel are more than twice as expensive in
$9
In For
general,
when
supply
and
demand
shift
in
opposite
directions,
we
can’t
Japan
most goods
and services,
it is
a in
bitmany
easier
toAsian
predict
changes in supply than
most European
countries
and
East
countries
8
Korea
predictchanges
what theinultimate
effect
will
befactors
onAccording
the that
quantity
bought
sold.
What we
demand.
Physical
affect
supply,
like
weather
or the availthan
in the
United
States.
to the
law ofand
demand,
7
can say
is
that
a
curve
that
shifts
a
disproportionately
greater
distance
than
the
this should
lead Europeans
to buy on
lessthan
gasoline
than tastes that affect
ability of inputs,
are easier
to get a handle
the fickle
Canada
France
6
Germany
other curve
will Still,
have
awith
disproportionately
effect
on
Americans—and
theyasdo.
Asgreater
you
can
see
fromthe
thequantity
figure,
demand.
supply
with
demand,
what
we
can
bestbought
predict are5 the
and sold. That said,
we
can
make
the
following
prediction
about
the
outcome
per person,
consume less than half as much fuel
effects of shifts
of theEuropeans
supply curve.
4
when the supply and
demand curves
shift
in opposite
directions:
as Americans,
because
they drive
smaller drilling
cars with technology signifiAs we mentioned
in mainly
the opening
story,
improved
3
United States
better
mileage.
• When
demand
decreases
and supply
increases,
equilibrium
price falls
but3-15 shows
cantly
increased
the supply
of natural
gasthe
from
2006 onward.
Figure
2
Prices
aren’t
the
only
factor
affecting
fuel
consumpthehow
change
the equilibrium
quantity
ambiguous. The original equilibrium 1is at
thisinshift
affected the
marketis equilibrium.
tion, but they’re probably the main cause of the difference
E1, demand
the pointincreases
of intersection
of the
originalthe
supply
curve, price
S1, with
equilibrium
• When
and supply
decreases,
equilibrium
risesan
but
between European and American fuel consumption per
0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
P1 and
equilibrium
As a result of the improved technology, suptheprice
change
in the
equilibriumquantity
quantityQis1.ambiguous.
person.
Consumption of gasoline
John Sciulli/Stringer/Getty Images
boxes apply economic
concepts to real-world
events in unexpected and
sometimes surprising
ways, generating a sense
of the power and breadth
of economics. The feature
furthers the book’s goal
of helping students build
intuition with real-world
examples.
Global Comparison
boxes use real data from
several countries and colorful
graphs to illustrate how and
why countries reach different
economic outcomes. The
boxes give students an
international perspective
that will expand their
understanding of economics.
F
•
ply increases and S shifts rightward to S . At the original price P , a surplus of
1
2
1
(gallons per day per capita)
But suppose that the demand
and supply curves
shift in the same direction.
gashappened
now exists
and the
market
no longer
in as
equilibrium.
The surplus
This isnatural
what has
in recent
years
in theisUnited
States,
the economy
causes
a fall
in World
and
an
increase
inM 2008,
the
quantity
demanded,
a downward
Source:
andD U.S.
2013.
has made
a gradual
recovery
from
of
resultingAdministration,
in an increase
84
Pprice
A R TDevelopment
2
Sthe
U PIndicators
Precession
LY A N D
E
AEnergy
N D Information
movement
along
thewedemand
curve.any
Thepredictions
new equilibrium
is at E2, with
in both demand
and supply.
Can
safely make
about the
anand
equilibrium
P2situation,
and an equilibrium
Q2 bought
. In the new equiP I T F A L L S changes in price
quantity? price
In this
the change quantity
in quantity
Louisiana
Drillersquantity
and Allegheny
Natural
Gas. For example at a price of around $2 per
E2,but
thethe
price
is lower
andisthe
equilibrium
is higher
than
and sold can belibrium
predicted,
change
in price
ambiguous.
The two
possible
WHICH CURVE IS IT, ANYWAY?
BTU,principle:
LouisianaWhen
Drillers
supplies 200,000 BTUs and Allegheny Natural Gas supplies
Thisand
candemand
be stated
as a shift
general
supply
outcomes whenbefore.
the supply
curves
in the same direction
(whichof a good or
When the price of some good or service
100,000 BTUs per year, making the quantity supplied to the market 300,000 BTUs.
service
increases,
price
of the good or service falls and the
youthis
should check
for yourself)
arethe
as equilibrium
follows:
changes, in general, we can say that
Clearly, the quantity supplied to the market at any given price is larger when
equilibrium quantity of the good or service rises.
reflects a change in either supply or• demand.
When both demand and supplyboxes
increase,
the
equilibrium
quantity
but
Natural
Gasrises
is
also
a producer than it would be if Louisiana Drillers were
clarifyAllegheny
concepts
that
are
easily
But it is easy to get confused about which
What happens
market when supply falls? A fall in supply leads
the change in equilibrium
pricetoisthe
ambiguous.
the only supplier. The quantity supplied at a given price would be even larger if we
one. A helpful clue is the direction of change
misunderstood
students
new
to
economics.
to a leftward
shift of the by
supply
curve.
At
the
original
price
a shortage
added a third
producer,
then
• When in
both demand and supply decrease, the equilibrium
quantity
falls
buta fourth, and so on. So an increase in the number of
in the quantity. If the quantity sold changes
now exists;
price rises and the quantity
KrugWellsEC4e_Micro_CH03.indd
71 as a result, the equilibrium
the change in equilibrium
price is ambiguous. producers leads to an increase in supply and a rightward shift of the supply curve. 9/30/14 1:27 PM
the same direction as the price—for example,
demanded falls. This describes what happened
toof
the
natural
For a review
themarket
factorsfor
that
shift supply, see Table 3-2.
if both the price and the quantity rise—this
Pitfalls
suggests that the demand curve has shifted.
If the price and the quantity move in opposite
directions, the likely cause is a shift of the
supply curve.
gas after Hurricane Katrina damaged natural gas production in the Gulf
of TABLE
Mexico3-2
in 2006.
We can
formulate
a general principle: When supply of
Factors
That
Shift Supply
a good
service decreases, the equilibrium price of the good
service
Whenor
this
Butorwhen
this rises
and
the equilibrium
quantity. .of
the good
or service falls. happens . . .
happens
...
. supply
increases
Price
KrugWellsEC4e_Micro_CH03.indd 94
FIGURE 3-15
9/23/14 9:34 AM
When the
Equilibrium and Shifts
ofprice
the Supply Curve
The original equilibrium in the market
is at E1. Improved technology causes
an increase in the supply of natural
gas and shifts the supply curve
rightward from S1 to S2. A new
equilibrium is established at E2, with
a lower equilibrium price, P 2, and a
higher equilibrium quantity, Q 2.
of an input
falls . . .
S1
Price of
natural gas
When the price
of an input
rises . . .
S2
Price
falls
Quantity
S1
S1
S2
Quantity
E2
Price
When the price of
a complement in
production rises . . .
S1
S2
An increase
in supply . . .
Price
. . . supply
When the price
of a substitute in
E1 of the original
good increases. . . . leads
production
rises . . .
to a
S2
. . . supply
of the good
decreases.
S1
Quantity
study aid for readers. Many incorporate
Price
visuals to help students grasp important
When the price
of a substitute in
economic concepts.
production P
falls
1 ...
xxii
. . . supply
of the good
increases.
S2
Summary Tables serve as a helpful
P2
. . . supply decreases
Price
movement along
the demand curve to
a lower equilibrium
price and higher
equilibrium quantity.
. . . supply
of the original
good increases.
Demand
S2
. . . supply
of the original
good decreases.
S1
Quantity
Price
When the price of
a complement in
production falls . . .
S2
S1
. . . supply
of the original
good decreases.
PR E FAC E
xxiii
TOOLS FOR LEARNING WALK THROUGH
BUSINESS
Business Cases
close each chapter,
applying key economic
principles to real-life
business situations
in both American and
international companies.
Each case concludes
with critical thinking
questions.
PA R T 2
I
S U P P LY A N D D E M A N D
WORK IT OUT
For interactive, step-by-step help in solving the following problem,
visit
by using the URL on the back cover of this book.
19. The accompanying table gives the annual U.S. demand
and supply schedules for pickup trucks.
Quantity of
trucks demanded
(millions)
Quantity of
trucks supplied
(millions)
$20,000
20
14
25,000
18
15
30,000
16
16
35,000
14
17
40,000
12
18
Price of truck
n a densely populated city like New York City, finding a taxi is a relatively easy
task on most days—stand on a corner, put out your arm and, usually, before
long an available cab stops to pick you up. And even before you step into the
car you will know approximately how much it will cost to get to your destination,
because taxi meter rates are set by city regulators and posted for riders.
But at times it is not so easy to find a taxi—on rainy days, during rush hour,
and at crowded locations where many people are looking for a taxi at the
same time. At such times, you could wait a very long while before finding
an available cab. As you wait, you will probably notice empty taxis passing you by—drivers who have quit working for the day and are headed
home or back to the garage. There will be drivers who might stop, but
then won’t pick you up because they find your destination inconvenient.
Moreover, there are times when it is simply impossible to hail a taxi—for
example, during a snowstorm or on New Year’s Eve when the demand for
taxis far exceeds the supply.
In 2009 two young entrepreneurs, Garrett Camp and Travis Kalanick,
founded Uber, a company that they believe offers a better way to get a ride.
Using a smartphone app, Uber serves as a clearinghouse connecting people
who want a ride to drivers with cars who are registered with Uber. Confirm
your location using the Uber app and you’ll be shown the available cars in
your vicinity. Tap “book” and you receive a text saying your car—typically a
spotless Lincoln Town Car—is on its way. At the end of your trip, fare plus tip
are automatically deducted from your credit card. As of 2014 Uber operates in
70 cities around the world and booked more than $1 billion in rides in 2013.
Given that Uber provides personalized service and better quality cars, their
fares are somewhat higher than regular taxi fares during normal driving days—a
situation that customers seem happy with. However, the qualification during normal driving hours is an important one because at other times Uber’s rates fluctuate. When a lot of people are looking for a car—such as during a snowstorm or on
New Year’s Eve—Uber uses what it calls surge pricing, setting the rate higher until
everyone who wants a car at the going price can get one. So during a recent New
York snowstorm, rides cost up to 8.25 times the standard price. Enraged, some of
Uber’s customers have accused them of price gouging.
98
PA R T 2
S U P P LY A N D D E M A N D
But according to Kalanick, the algorithm that Uber uses to determine the
surge price is set to leave as few people as possible without a ride, and he’s just
SUMMARY
doing what is necessary to keep customers happy. As he explains, “We do not own
cars and
nor demand
do we employ
drivers.
Higher prices
required
inshifts
order
cars
on
ingare
supply,
they mean
of to
theget
supply
curve—a
1. The supply
model illustrates
how
the road
and keep
them
the road duringchange
the busiest
times.”
Thisatexplanation
in the quantity
supplied
any given price. An
a competitive
market,
one with
manyon
buyers
increase
supply
causes
a rightward
the supand sellers,
none of whom by
canone
influence
marketwho said,
was confirmed
Uberthedriver
“If I indon’t
have
anything
toshift
do ofand
ply curve. A decrease in supply causes a leftward shift.
price, works.
see a surge price, I get out there.”
Mark Avery/Zuma Wire/Alamy
102
An Uber Way to Get a Ride
CASE
2. The demand schedule shows the quantity demand-
8. There are five main factors that shift the supply curve:
ed at each price and is represented graphically by
• A change in input prices
a demand
curve. The law
of demand
says that
QUESTIONS
FOR
THOUGHT
• A change in the prices of related goods and services
demand curves slope downward; that is, a higher
• A change in technology
price for
good or service
demand set
a in the market for rides in New York City?
1. a Before
Uber,leads
howpeople
weretoprices
• A change in expectations
smaller quantity,
things equal. market?
Was itother
a competitive
• A change in the number of producers
3. A movement along the demand curve occurs when a
2. What accounts for the fact that during good
weather
there
areortypically
supply
service
is the
price change leads to a change in the quantity demand- C H A9.P The
T E Rmarket
3
SU
P P LY curve
A N D Dfor
EMa
A Ngood
D
99
enough taxis
everyone
who wants one,
but during
snowstorms
therecurves
typi-of all
horizontal
sum of the
individual supply
ed. When economists
talk of for
increasing
or decreasing
producers
in
the
market.
demand, they
mean
shiftsenough?
of the demand curve—a
cally
aren’t
a. Plot the demand and supply curves using these
schedules. Indicate the equilibrium price and
quantity on your diagram.
b. Suppose the tires used on pickup trucks are
found to be defective. What would you expect to
happen in the market for pickup trucks? Show
this on your diagram.
c Suppose that the U.S. Department of
Transportation imposes costly regulations on
manufacturers that cause them to reduce supply
by one-third at any given price. Calculate and plot
the new supply schedule and indicate the new
equilibrium price and quantity on your diagram.
KrugWellsEC4e_Micro_CH03.indd 97
NEW! Work It Out appears
in all end-of-chapter problem sets,
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PROBLEMS
change in the quantity demanded at any given price.
10. The supply and demand model is based on the princi3. How
doescauses
Uber’s
surge pricing
problem described in the previous
An increase
in demand
a rightward
shift of thesolve the
ple that the price in a market moves to its equilibrium
question?
Assess
Kalanick’s
claim
that price,
the
price
isRams
set cotton
to leave
asthe
few
people
demand
A decrease
in demand
causes a leftward
b.
The market
for St.
Louis
T-shirts
1. A survey indicated
that curve.
chocolate
is the
most
popular
or
market-clearing
price,
price
at which
shift.
flavor of ice cream
in America.
For each
of the a
followpossible
without
ride.
Case 1: The the
Rams
win the
Super Bowl.
quantity
demanded
is equal to the quantity suping, indicate the possible effects on demand, supply, or
This
quantity
is the equilibrium quantity.
price of
cotton
increases.
4. There are five main factors that shift the demand Case 2: The plied.
97 When
both as well as equilibrium price and quantity of chocothe
price
is
above
its
market-clearing
level, there is a
curve:
c. The market for bagels
late ice cream.
surplus that pushes the price down. When the price is
• A change in the prices of related goods or services,
Case 1: People realize how fattening bagels are.
a. A severe drought in the Midwest causes dairy farmers
below its market-clearing level, there is a shortage that
such as
or complements
Case 2: People
havethe
lessprice
timeup.
to make themselves a
to reduce the number
of substitutes
milk-producing
cattle in their
pushes
• AThese
change
in income:
cooked breakfast.
herds by a third.
dairy
farmers when
supplyincome
cream rises, the demand
11.
An
increase
in
demand
increases both the equilibfor
normal
goods
increases
and
the
demand
for
that is used to manufacture chocolate ice cream.
d. The market for the Krugman and Wells economics
rium price and the equilibrium quantity; a decrease in
goodsMedical
decreases
b. A new report by inferior
the American
Association
textbook
demand
has
the
opposite
effect. An increase in supply
• A change
in in
tastes
reveals that chocolate
does,
fact, have significant
Case 1: Yourreduces
professor
makes it required reading for 9/23/14 9:34 AM
the equilibrium price and increases the equihealth benefits.
• A change in expectations
all of his or her students.
librium quantity; a decrease in supply has the opposite
c. The discovery•ofAcheaper
vanilla
change synthetic
in the number
of flavoring
consumers
Case 2: Printing
costs for textbooks are lowered by
effect.
lowers the price of vanilla ice cream.
the use of synthetic paper.
5. The market demand curve for a good or service is the
12. Shifts of the demand curve and the supply curve can
d. New technology for mixing and freezing ice cream
horizontal sum of the individual demand curves
of assume that each person in the United States con5. Let’s
happen simultaneously. When they shift in opposite
lowers manufacturers’ costs of producing chocolate
all
consumers in the market.
sumes an average
of 37 gallons
of soft
drinks (nondiet)
98 icePcream.
ART 2
S U P P LY A N D D E M A N D
directions,
the change
in equilibrium
price is predictat an average able
pricebut
of the
$2 change
per gallon
and that the
U.S. is not.
in equilibrium
quantity
6. The supply schedule shows the quantity supplied at
2. In a supply and demand diagram, draw the shift of the
population is 294 million. At a price of $1.50 per gallon,
When they shift in the same direction, the change in
each price and is represented graphically by a supply
demand curve for hamburgers in your hometown due
each individual consumer would demand 50 gallons of
SUMMARY
equilibrium quantity is predictable but the change
usually
slope
upward.
to the following curve.
events.Supply
In eachcurves
case, show
the
effect
on
soft drinks. From this information about the individual
in equilibrium price is not. In general, the curve that
price
and quantity.
demand
calculate
sched7. Ademand
movement
along
the supply
curve occurs when
ing
supply,schedule,
they mean
shifts ofthe
themarket
supplydemand
curve—a
1.equilibrium
The supply and
model
illustrates
how
shifts the greater
distance
has and
a greater
effect on the
ule
the prices
ofgiven
$1.50
$2 per
a.
price of tacos
increases.
a price
change
leads
to abuyers
change in the quantitychange
sup-forinsoft
the drinks
quantityfor
supplied
at any
price. An
a The
competitive
market,
one with
many
changes in equilibrium price and quantity.
gallon.
plied.
When
economists
talk
of
increasing
or
decreasincrease in supply causes a rightward shift of the supand
none sellers
of whom
canthe
influence
market
b.
Allsellers,
hamburger
raise
price ofthe
their
french
curve. that
A decrease
in supply
causes
a leftward
shift.
price,
fries.works.
6.ply
Suppose
the supply
schedule
of Maine
lobsters
is as
End-of-Chapter Reviews include a
brief but complete summary of key concepts,
a list of key terms, and a comprehensive,
high-quality set of end-of-chapter Problems.
Income
fallsschedule
in town. shows
Assume
that
hamburgers
are a
2.c.
The
demand
the
quantity
demand-
KEYmost
TERMS
people.
ednormal
at eachgood
pricefor
and is represented
graphically by
follows:
8. There
are five main factors that shift the supply curve:
• A change in input prices
Quantity of
lobster
Competitive
market,
p.
68 hamburgers
Movement
along
the supply curve,
d.
in town.
Assume
that
a Income
demandfalls
curve.
The law
of demand
says that are Substitutes, p. 74 Price of lobster
• A change in the prices of relatedp.
goods
services
supplied
(pounds)
80 and
Supply
and
demand
model,
p. 68
Complements, p. 74(per pound)
an inferior
good
for
most
people.
demand
curves
slope
downward;
that is,
a higher
• A change
in$25
technology
Input, p. 800
82
Demand
schedule,
p.
69
Normal
good,
p.
74
price
good or
service
leads
to demand a
e.
Hot for
dogastands
cut
the price
ofpeople
hot dogs.
Individual supply curve, p. 83
• A change
expectations
Quantity
demanded,
p. 69
Inferior good,
p. 74 in 20
smaller quantity,
other
things equal.
700
3. The market for many goods changes in predictable ways
Equilibrium price, p. 86
Demand curve, p. 69
Individual
curve,
p. number
76
• demand
A change
in the
of producers
600 quantity, p. 86
to the
timethe
of year,
in response
to events
such
3.according
A movement
along
demand
curve
occurs
when
aQuantity supplied, p. 79 15
Equilibrium
Law of demand, p. 70
9. The market supply curve for a good or service
as
holidays,
vacation
seasonal
changesdemandin proprice
changeShift
leadsoftothe
atimes,
change
in the quantity
500 is the
Market-clearing
price, p. 86
demand curve, p. 72
Supply schedule, p. 79 10
horizontal sum of the individual supply curves of all
duction,
so on. Using
supply
and demand,
explain
ed. Whenand
economists
talk of
increasing
or decreasing
Surplus, 400
p. 88
Movement along the demand curve,
5
Supply curve, p. 79
the
change
in price
in each of the following cases. Note
producers in the market.
demand,
they
mean
p.
72 shifts of the demand curve—a Shift of the supply curve, p. 80
Shortage, p. 88
xxiii
that
supply
and
demand
may shiftatsimultaneously.
change
in the
quantity
demanded
any given price.
a.
Lobster
prices
usuallycauses
fall during
the summer
An
increase
in demand
a rightward
shift ofpeak
the
lobster
harvest
season,
the fact
thata people
demand curve. A decreasedespite
in demand
causes
leftward
like to eat lobster during the summer more than at
shift.
10. The
supply that
and demand
model iscan
based
theonly
princiSuppose
Maine lobsters
be on
sold
in the
United
States.
U.S. demand
schedule
for Maine
ple
that the
price The
in a market
moves to
its equilibrium
lobsters
is as follows:
price,
or market-clearing
price, the price at which
the quantity demanded is equal to the quantity sup-
xxiv
PR E FAC E
Organization
of Book:
This Book:
What’s Core,
What’s
Optional
Organization
of This
What’s
Core,
What’s
Optional
To help with planning your course, following is a list of
what we view as core chapters and those that could be
considered optional, along with a brief description of the
coverage in each chapter.
Core
Optional
Introduction: The Ordinary Business of Life
Initiates students into the study of economics with basic terms
and explains the difference between microeconomics and
macroeconomics.
1. First Principles
Outlines 12 principles underlying the study of economics:
principles of individual choice, interaction between individuals,
and economy-wide interaction.
2. Economic Models: Trade-offs and Trade
Employs two economic models—the production possibilities
frontier and comparative advantage—as an introduction to gains
from trade and international comparisons.
Chapter 2 Appendix: Graphs in Economics
Offers a comprehensive review of graphing and math skills for
students who would find a refresher helpful and to prepare them
for better economic literacy.
3. Supply and Demand
Covers the essentials of supply, demand, market equilibrium,
surplus, and shortage.
4. Price Controls and Quotas: Meddling with Markets
Covers market interventions and their consequences: price and
quantity controls, inefficiency, and deadweight loss.
5. International Trade
Here we trace the sources of comparative advantage, consider tariffs
and quotas, and explore the politics of trade protection, including
coverage on the controversy over imports from low-wage countries.
Chapter 5 Appendix: Consumer and
Producer Surplus
Introduces students to market efficiency, the ways markets fail, the
roles of prices as signals, and property rights.
6. Macroeconomics: The Big Picture
Introduces the big ideas of macroeconomics with an overview of
recessions and expansions, employment and unemployment,
long-run growth, inflation versus deflation, and the open economy.
7. GDP and CPI: Tracking the Macroeconomy
Explains how the numbers macroeconomists use are calculated
and why, including the basics of national income accounting and
price indexes.
8. Unemployment and Inflation
Covers the measurement of unemployment, the reasons why
positive employment exists even in booms, and the problems
posed by inflation.
9. Long-Run Economic Growth
Emphasizes an international perspective—economic growth is
about the world as a whole—and explains why some countries
have been more successful than others.
10. Savings, Investment Spending, and the Financial
System
Introduces students to financial markets and institutions, loanable
funds and the determination of interest rates. Includes coverage of
present value in the chapter proper and in an appendix.
Chapter 10 Appendix: Toward a Fuller
Understanding of Present Value
Expands on the coverage of present value in the chapter.
PR E FAC E
Core
11. Income and Expenditure
Addresses the determinants of consumer and investment
spending, introduces the famous 45-degree diagram, and explains
the logic of the multiplier.
xxv
Optional
Chapter 11 Appendix: Deriving the Multiplier
Algebraically
A rigorous and mathematical approach to deriving the multiplier.
12. Aggregate Demand and Aggregate Supply
Provides the traditional focus on aggregate price level using the
traditional approach to AD-AS. It also covers the ability of the
economy to recover in the long run.
13. Fiscal Policy
Provides an analysis of the role of discretionary fiscal policy,
automatic stabilizers, and long-run issues of debt and solvency.
Chapter 13 Appendix: Taxes and the Multiplier
A rigorous derivation of the roles of taxes in reducing the size of
the multiplier and acting as an automatic stabilizer.
14. Money, Banking, and the Federal Reserve System
Covers the roles of money, the ways in which banks create money,
and the structure and the role of the Federal Reserve and other
central banks.
15. Monetary Policy
Covers the role of Federal Reserve policy in driving interest rates
and aggregate demand. It includes a section bridging the short
and long run by showing how interest rates set in the short run
reflect the supply and demand of savings in the long run.
Chapter 15 Appendix: Reconciling the Two Models
of the Interest Rate
This appendix explains why the loanable funds model (long-run
discussions) and the liquidity preference approach (short-run
discussions) are both valuable.
16. Inflation, Disinflation, and Deflation
Covers the causes and consequences of inflation, the large cost
deflation imposes on the economy, and the danger that disinflation
leads the economy into a liquidity trap.
17. Crises and Consequences
Provides an up-to-date look at the recent financial crisis, starting
with the Lehman Brothers collapse, integrating coverage about
the dangers posed by banking, shadow banking, asset bubbles,
and financial contagion.
18. Macroeconomics: Events and Ideas
Provides a unique overview of the history of macroeconomic
thought, set in the context of changing policy concerns, and the
current state of macroeconomic debates.
19. Open-Economy Macroeconomics
Analyzes special issues raised for macroeconomics in an open
economy: a weak dollar, foreign accumulation of dollar reserves,
and debates surrounding the euro.
xxvi
PR E FAC E
Resources for Students and Instructors
www.macmillanhighered.com/launchpad/krugmanwellsmacro4
Our new course space,
combines an interactive
e-Book with high-quality multimedia content and readymade assessment options, including LearningCurve
adaptive quizzing. Pre-built, curated units are easy
to assign or adapt with your own material, such as
readings, videos, quizzes, discussion groups, and
more. LaunchPad also provides access to a gradebook
that provides a clear window on performance for your
whole class, for individual students, and for individual
assignments.
For Students
Living Graphs Based on figures from the text, Living
is an adaptive quizzing engine that
automatically adjusts questions to the student’s mastery
level. With LearningCurve activities, each student follows a unique path to understanding the material. The
more questions a student answers correctly, the more
difficult the questions become. Each question is written specifically for the text and is linked to the relevant
e-Book section. LearningCurve also provides a personal study plan for students as well as complete metrics
for instructors. Proven to raise student performance,
LearningCurve serves as an ideal formative assessment
and learning tool. For detailed information, visit http://
learningcurveworks.com.
NEW Work It Out Tutorials New to this edition,
these tutorials guide students through the process of
applying economic analysis and math skills to solve the
final problem in each chapter. Choice-specific feedback
and video explanations provide students with interactive assistance for each step of the problem.
Economics in Action Based on the feature from the
text, these real-life applications are accompanied by
assessment and links to additional data.
Graphs are animated and interactive graphs that first
demonstrate a concept to students and then ask them
to manipulate the graph or answer questions to check
understanding.
Interactive Tutorials These interactive modules are
designed to teach students key principles and concepts
through example problems, animated graphs, and
interactive activities.
For Instructors
Graphing Questions As a further question bank for
instructors building assignments and tests, the electronically gradable graphing problems utilize our own
robust graphing engine. In these problems, students
will be asked to draw their response to a question, and
the software will automatically grade that response.
Graphing questions are tagged to appropriate textbook
sections and range in difficulty level and skill.
PR E FAC E
Test Bank The Test Bank, coordinated by Doris
Bennett, Jacksonville State University, provides a wide
range of questions appropriate for assessing your students’ comprehension, interpretation, analysis, and synthesis skills. The Test Bank offers multiple-choice, true/
false, and short-answer questions designed for comprehensive coverage of the text concepts. Questions are categorized according to difficulty level (easy, moderate,
and difficult) and skill descriptor (definitional, conceptbased, critical thinking, and analytical thinking) and
are tagged to their appropriate textbook section.
End-of-Chapter Problems The end-of-chapter problems from the text have been converted to a multiple-choice
format with answer-specific feedback. These problems can
be assigned in homework assignments or quizzes.
Practice and Graded Homework Assignments
Each LaunchPad unit contains prebuilt assignments,
providing instructors with a curated set of multiplechoice and graphing questions that can be easily
assigned for practice or graded assessment.
Instructor’s Resource Manual The Instructor’s
Resource Manual, revised by Nora Underwood,
University of Central Florida, is a resource meant to
provide materials and tips to enhance the classroom
experience as it provides chapter objectives, chapter
outlines, and teaching tips and ideas.
Solutions Manual Prepared by the authors of the
text, the Solutions Manual contains detailed solutions
to all of the end-of-chapter problems from the textbook.
Solutions to business case study Questions for Thought
are also provided.
Interactive Presentation Slides This set of
Interactive Presentation slides, designed by Solina
Lindahl, CalPoly San Luis Obispo, is available as an
alternative to traditional lecture outline slides. The
slides are brief, interactive, and visually interesting to
keep students’ attention in class. They offer instructors
the following:
• Additional graphics and animations to demonstrate
key concepts
• Many additional (and interesting) real-world
examples
• Hyperlinks to other relevant outside sources, including links to videos, that provide even more helpful
real-world examples to illustrate key concepts
• Opportunities to incorporate active learning in your
classroom
xxvii
Additional Online Offerings
Aplia Worth/Aplia courses are all available
with digital textbooks, interactive assignments, and detailed feedback. For a preview of
Aplia materials and to learn more, visit www.aplia.com/
worth.
www.saplinglearning.com
Sapling Learning provides the most
effective interactive homework and
instruction that improves student-learning outcomes
for the problem-solving disciplines.
Acknowledgments
We are indebted to the following reviewers, class testers, focus group participants, and other consultants
for their suggestions and advice on previous editions.
Carlos Aguilar, El Paso Community College
Giuliana Campanelli Andreopoulos, William Patterson University
Seemi Ahmad, Dutchess Community College
Terence Alexander, Iowa State University
Morris Altman, University of Saskatchewan
Farhad Ameen, State University of New York, Westchester
Community College
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Indianapolis
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Joni S. Charles, Texas State University, San Marcos
xxviii
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xxix
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Introduction: The Ordinary
Business of Life
INTRO
Flickr Editorial/Getty Images
ANY GIVEN SUNDAY
Delivering the goods: the market economy in action.
I
T’S SUNDAY AFTERNOON IN THE
spring of 2014, and Route 1 in central New Jersey is a busy place.
Thousands of people crowd the shopping malls that line the road for 20
miles, all the way from Trenton to New
Brunswick. Most of the shoppers are
cheerful—and why not? The stores in
those malls offer an extraordinary range
of choice; you can buy everything from
the latest tablet and fashions to caramel
macchiattos.
There are probably 100,000 distinct
items available along that stretch of road.
And most of these items are not luxury
goods that only the rich can afford; they
are products that millions of Americans
can and do purchase every day.
The scene along Route 1 on this spring
day is, of course, perfectly ordinary—
very much like the scene along hundreds
of other stretches of road, all across
America, that same afternoon. And the
discipline of economics is mainly concerned with ordinary things. As the
great nineteenth-century economist
Alfred Marshall put it, economics is “a
study of mankind in the ordinary business of life.”
What can economics say about this
“ordinary business”? Quite a lot, it turns
out. What we’ll see in this book is that
even familiar scenes of economic life
pose some very important questions—
questions that economics can help
answer. Among these questions are:
• How does our economic system
work? That is, how does it manage to
deliver the goods?
• When and why does our economic
system go astray, leading people into
counterproductive behavior?
• Why are there ups and downs in
the economy? That is, why does the
economy sometimes have a “bad year”?
• Finally, why is the long run mainly a
story of ups rather than downs? That
is, why has America, along with other
advanced nations, become so much
richer over time?
Let’s take a look at these questions
and offer a brief preview of what you will
learn in this book.
1
2 P A R T 1
W H AT I S E C O N O M I C S ?
The Invisible Hand
An economy is a system for
coordinating society’s productive
activities.
Economics is the social science
that studies the production,
distribution, and consumption of
goods and services.
A market economy is an economy
in which decisions about production
and consumption are made by
individual producers and consumers.
The invisible hand refers to the way
in which the individual pursuit of selfinterest can lead to good results for
society as a whole.
That ordinary scene in central New Jersey would not have looked at all ordinary
to an American from colonial times—say, one of the patriots who helped George
Washington win the Battle of Trenton in 1776. At the time, Trenton was a small
village, and farms lined the route of Washington’s epic night march from Trenton
to Princeton—a march that took him right past the future site of the giant
Quakerbridge shopping mall.
Imagine that you could transport an American from the colonial period forward in time to our own era. (Isn’t that the plot of a movie? Several, actually.)
What would this time-traveler find amazing?
Surely the most amazing thing would be the sheer prosperity of modern
America—the range of goods and services that ordinary families can afford. Looking
at all that wealth, our transplanted colonial would wonder, “How can I get some of
that?” Or perhaps he would ask himself, “How can my society get some of that?”
The answer is that to get this kind of prosperity, you need a well-functioning
system for coordinating productive activities—the activities that create the goods
and services people want and get them to the people who want them. That kind
of system is what we mean when we talk about the economy. And economics is
the social science that studies the production, distribution, and consumption of
goods and services.
An economy succeeds to the extent that it, literally, delivers the goods. A timetraveler from the eighteenth century—or even from 1950—would be amazed at
how many goods and services the modern American economy delivers and at how
many people can afford them. Compared with any past economy and with all but
a few other countries today, America has an incredibly high standard of living.
So our economy must be doing something right, and the time-traveler might
want to compliment the person in charge. But guess what? There isn’t anyone in
charge. The United States has a market economy, in which production and consumption are the result of decentralized decisions by many firms and individuals.
There is no central authority telling people what to produce or where to ship it.
Each individual producer makes what he or she thinks will be most profitable;
each consumer buys what he or she chooses.
The alternative to a market economy is a command economy, in which there
is a central authority making decisions about production and consumption.
Command economies have been tried, most notably in the former Soviet Union
between 1917 and 1991. But they didn’t work very well. Producers in the Soviet
Union routinely found themselves unable to produce because they did not have
crucial raw materials, or they succeeded in producing but then found that nobody
wanted their products. Consumers were often unable to find necessary items—
command economies are famous for long lines at shops.
Market economies, however, are able to coordinate even highly complex activities and to reliably provide consumers with the goods and services they want.
Indeed, people quite casually trust their lives to the market system: residents of
any major city would starve in days if the unplanned yet somehow orderly actions
of thousands of businesses did not deliver a steady supply of food. Surprisingly,
the unplanned “chaos” of a market economy turns out to be far more orderly than
the “planning” of a command economy.
In 1776, in a famous passage in his book The Wealth of Nations, the pioneering Scottish economist Adam Smith wrote about how individuals, in pursuing
their own interests, often end up serving the interests of society as a whole. Of
a businessman whose pursuit of profit makes the nation wealthier, Smith wrote:
“[H]e intends only his own gain, and he is in this, as in many other cases, led by
an invisible hand to promote an end which was no part of his intention.” Ever
since, economists have used the term invisible hand to refer to the way a market
economy manages to harness the power of self-interest for the good of society.
INTRODUCTION
THE ORDINARY BUSINESS OF LIFE
The study of how individuals make decisions and how these decisions interact is called microeconomics. One of the key themes in microeconomics is the
validity of Adam Smith’s insight: individuals pursuing their own interests often
do promote the interests of society as a whole.
So part of the answer to our time-traveler’s question—“How can my society
achieve the kind of prosperity you take for granted?”—is that his society should
learn to appreciate the virtues of a market economy and the power of the invisible hand.
But the invisible hand isn’t always our friend. It’s also important to understand when and why the individual pursuit of self-interest can lead to counterproductive behavior.
My Benefit, Your Cost
3
Microeconomics is the branch of
economics that studies how people
make decisions and how these
decisions interact.
When the individual pursuit of selfinterest leads to bad results for
society as a whole, there is market
failure.
A recession is a downturn in the
economy.
Macroeconomics is the branch
of economics that is concerned
with overall ups and downs in the
economy.
One thing that our time-traveler would not admire about modern Route 1 is the
traffic. In fact, although most things have gotten better in America over time,
traffic congestion has gotten a lot worse.
When traffic is congested, each driver is imposing a cost on all the other drivers on the road—he is literally getting in their way (and they are getting in his
way). This cost can be substantial: in major metropolitan areas, each time someone drives to work, instead of taking public transportation or working at home,
he can easily impose $15 or more in hidden costs on other drivers. Yet when
deciding whether or not to drive, commuters have no incentive to take the costs
they impose on others into account.
Traffic congestion is a familiar example of a much broader problem: sometimes the individual pursuit of one’s own interest, instead of promoting the
interests of society as a whole, can actually make society worse off. When this
happens, it is known as market failure. Other important examples of market
failure involve air and water pollution as well as the overexploitation of natural
resources such as fish and forests.
The good news, as you will learn as you use this book to study microeconomics,
is that economic analysis can be used to diagnose cases of market failure. And
often, economic analysis can also be used to devise solutions for the
problem.
Route 1 was bustling on that day in 2014. But if you’d visited the
malls in 2008, the scene wouldn’t have been quite as cheerful. That’s
because New Jersey’s economy, along with that of the United States
as a whole, was depressed in 2008: in early 2007, businesses began
laying off workers in large numbers, and employment didn’t start
bouncing back until the summer of 2009.
Such troubled periods are a regular feature of modern economies.
The fact is that the economy does not always run smoothly: it experiences fluctuations, a series of ups and downs. By middle age, a
typical American will have experienced three or four downs, known
as recessions. (The U.S. economy experienced serious recessions
beginning in 1973, 1981, 1990, 2001, and 2007.) During a severe
recession, millions of workers may be laid off.
Like market failure, recessions are a fact of life; but also like market failure, they are a problem for which economic analysis offers
some solutions. Recessions are one of the main concerns of the branch
of economics known as macroeconomics, which is concerned with
© Dave Carpenter/Cartoonstock
Good Times, Bad Times
“Remember, an economic boom is usually
followed by an economic kaboom.”
4 P A R T 1
W H AT I S E C O N O M I C S ?
Economic growth is the growing
ability of the economy to produce
goods and services.
the overall ups and downs of the economy. If you study macroeconomics, you will
learn how economists explain recessions and how government policies can be
used to minimize the damage from economic fluctuations.
Despite the occasional recession, however, over the long run the story of the
U.S. economy contains many more ups than downs. And that long-run ascent is
the subject of our final question.
Onward and Upward
At the beginning of the twentieth century, most Americans lived under conditions
that we would now think of as extreme poverty. Only 10% of homes had flush
toilets, only 8% had central heating, only 2% had electricity, and almost nobody
had a car, let alone a washing machine or air conditioning.
Such comparisons are a stark reminder of how much our lives have been
changed by economic growth, the growing ability of the economy to produce
goods and services. Why does the economy grow over time? And why does
economic growth occur faster in some times and places than in others? These are
key questions for economics because economic growth is a good thing, as those
shoppers on Route 1 can attest, and most of us want more of it.
An Engine for Discovery
We hope we have convinced you that the “ordinary business of life” is really quite
extraordinary, if you stop to think about it, and that it can lead us to ask some
very interesting and important questions.
In this book, we will describe the answers economists have given to these
questions. But this book, like economics as a whole, isn’t a list of answers: it’s an
introduction to a discipline, a way to address questions like those we have just
asked. Or as Alfred Marshall, who described economics as a study of the “ordinary business of life,” put it: “Economics . . . is not a body of concrete truth, but
an engine for the discovery of concrete truth.”
So let’s turn the key and start the ignition.
KEY TERMS
Economy, p. 2
Economics, p. 2
Market economy, p. 2
Invisible hand, p. 2
Microeconomics, p. 3
Market failure, p. 3
Recession, p. 3
Macroeconomics, p. 3
Economic growth, p. 4
First Principles
CHAPTER
1
COMMON GROUND
s
What You Will Learn
in This Chapter
A set of principles for
•understanding
the economics of
how individuals make choices
A set of principles for
•understanding
how economies
work through the interaction of
individual choices
A set of principles for
•understanding
economy-wide
Audrey Rudakov/Bloomberg via Getty Images
interactions
One must choose.
T
HE ANNUAL MEETING OF THE
American Economic Association
draws thousands of economists,
young and old, famous and obscure.
There are booksellers, business meetings, and quite a few job interviews. But
mainly the economists gather to talk
and listen. During the busiest times,
60 or more presentations may be taking place simultaneously, on questions
that range from financial market crises
to who does the cooking in two-earner
families.
What do these people have in common? An expert on financial markets
probably knows very little about the
economics of housework, and vice
versa. Yet an economist who wanders
into the wrong seminar and ends up listening to presentations on some unfamiliar topic is nonetheless likely to hear
much that is familiar. The reason is
that all economic analysis is based on a
set of common principles that apply to
many different issues.
Some of these principles involve individual choice—for economics is, first of
all, about the choices that individuals
make. Do you save your money and take
the bus or do you buy a car? Do you keep
your old smartphone or upgrade to a new
one? These decisions involve making
a choice from among a limited number of alternatives—limited because no
one can have everything that he or she
wants. Every question in economics at
its most basic level involves individuals
making choices.
But to understand how an economy
works, you need to understand more than
how individuals make choices. None of us
are Robinson Crusoe, alone on an island.
We must make decisions in an environment
that is shaped by the decisions of others.
Indeed, in a modern economy even
the simplest decisions you make—say,
what to have for breakfast—are shaped
by the decisions of thousands of other
people, from the banana grower in Costa
Rica who decided to grow the fruit you
eat to the farmer in Iowa who provided
the corn in your cornflakes.
Because each of us in a market economy
depends on so many others—and they, in
turn, depend on us—our choices interact.
So although all economics at a basic
level is about individual choice, in order
to understand how market economies
behave we must also understand economic
interaction—how my choices affect your
choices, and vice versa.
Many important economic interactions
can be understood by looking at the markets for individual goods, like the market
for corn. But an economy as a whole has
ups and downs, and we therefore need to
understand economy-wide interactions as
well as the more limited interactions that
occur in individual markets.
In this chapter, we will look at twelve
basic principles of economics—four principles involving individual choice, five
involving the way individual choices interact, and three more involving economywide interactions.
5
6
PA R T 1
W H AT I S E C O N O M I C S ?
Principles That Underlie Individual Choice:
The Core of Economics
Every economic issue involves, at its most basic level, individual choice—decisions
by an individual about what to do and what not to do. In fact, you might say that it
isn’t economics if it isn’t about choice.
Step into a big store like a Walmart or Target. There are thousands of different
products available, and it is extremely unlikely that you—or anyone else—could
afford to buy everything you might want to have. And anyway,
The Principles of
there’s only so much space in your dorm room or apartment.
TABLE 1-1
Individual Choice
So will you buy another bookcase or a mini-refrigerator? Given
1. People must make choices because resources are
limitations on your budget and your living space, you must
scarce.
choose which products to buy and which to leave on the shelf.
2. The opportunity cost of an item—what you must give
The fact that those products are on the shelf in the first place
up in order to get it—is its true cost.
involves choice—the store manager chose to put them there, and
the manufacturers of the products chose to produce them. All
3. “How much” decisions require making trade-offs at the
margin: comparing the costs and benefits of doing a
economic activities involve individual choice.
little bit more of an activity versus doing a little bit less.
Four economic principles underlie the economics of indi4. People usually respond to incentives, exploiting
vidual choice, as shown in Table 1-1. We’ll now examine each of
opportunities to make themselves better off.
these principles in more detail.
Principle #1: Choices Are Necessary
Because Resources Are Scarce
You can’t always get what you want. Everyone would like to have a beautiful house
in a great location (and have help with the housecleaning), a new car or two, and
a nice vacation in a fancy hotel. But even in a rich country like the United States,
not many families can afford all that. So they must make choices—whether to go
to Disney World this year or buy a better car, whether to make do with a small
backyard or accept a longer commute in order to live where land is cheaper.
Limited income isn’t the only thing that keeps people from having everything
they want. Time is also in limited supply: there are only 24 hours in a day. And
because the time we have is limited, choosing to spend time on one activity also
means choosing not to spend time on a different activity—studying for an exam
means forgoing a night spent watching a movie. Indeed, many people are so
limited by the number of hours in the day that they are willing to trade money
for time. For example, convenience stores normally charge higher prices than a
regular supermarket. But they fulfill a valuable role by catering to time-pressured
customers who would rather pay more than travel farther to the supermarket.
This leads us to our first principle of individual choice:
People must make choices because resources are scarce.
Individual choice is the decision
by an individual of what to do, which
necessarily involves a decision of
what not to do.
A resource is anything that can be
used to produce something else.
Resources are scarce—not enough
of the resources are available to
satisfy all the various ways a society
wants to use them.
A resource is anything that can be used to produce something else. Lists of
the economy’s resources usually begin with land, labor (the time of workers), capital (machinery, buildings, and other man-made productive assets), and human
capital (the educational achievements and skills of workers). A resource is scarce
when there’s not enough of the resource available to satisfy all the ways a society
wants to use it.
There are many scarce resources. These include natural resources that come
from the physical environment, such as minerals, lumber, and petroleum. There
is also a limited quantity of human resources, such as labor, skill, and intelligence. And in a growing world economy with a rapidly increasing human population, even clean air and water have become scarce resources.
Just as individuals must make choices, the scarcity of resources means that
society as a whole must make choices. One way a society makes choices is by
CHAPTER 1
FIRST PRINCIPLES
Principle #2: The True Cost of Something
Is Its Opportunity Cost
Ben Heys/Shutterstock
allowing them to emerge as the result of many individual choices, which is what
usually happens in a market economy. For example, Americans as a group have
only so many hours in a week: how many of those hours will they spend going to
supermarkets to get lower prices, rather than saving time by shopping at convenience stores? The answer is the sum of individual decisions: each of the millions
of individuals in the economy makes his or her own choice about where to shop,
and the overall choice is simply the sum of those individual decisions.
But for various reasons, there are some decisions that a society decides are
best not left to individual choice. For example, the authors live in an area that
until recently was mainly farmland but is now being rapidly built up. Most local
residents feel that the community would be a more pleasant place to live if some
of the land was left undeveloped. But no individual has an incentive to keep his or
her land as open space, rather than sell it to a developer. So a trend has emerged
in many communities across the United States of local governments purchasing
undeveloped land and preserving it as open space.
We’ll see in later chapters why decisions about how to use scarce resources
are often best left to individuals but sometimes should be made at a higher,
community-wide, level.
Resources are scarce.
It is the last term before you graduate, and your class schedule allows you to take
only one elective. There are two, however, that you would really like to take: Intro
to Computer Graphics and History of Jazz.
Suppose you decide to take the History of Jazz course. What’s the cost of that
decision? It is the fact that you can’t take the computer graphics class, your next
best alternative choice. Economists call that kind of cost—what you must give up
in order to get an item you want—the opportunity cost of that item. This leads
us to our second principle of individual choice:
The opportunity cost of an item—what you must give up in order to
get it—is its true cost.
So the opportunity cost of taking the History of Jazz class is the benefit you
would have derived from the Intro to Computer Graphics class.
The concept of opportunity cost is crucial to understanding individual choice
because, in the end, all costs are opportunity costs. That’s because every choice
you make means forgoing some other alternative.
Sometimes critics claim that economists are concerned only with costs and
benefits that can be measured in dollars and cents. But that is not true. Much
economic analysis involves cases like our elective course example, where it costs
no extra tuition to take one elective course—that is, there is no direct monetary
cost. Nonetheless, the elective you choose has an opportunity cost—the other
desirable elective course that you must forgo because your limited time permits
taking only one. More specifically, the opportunity cost of a choice is what you
forgo by not choosing your next best alternative.
You might think that opportunity cost is an add-on—that is, something
additional to the monetary cost of an item. Suppose that an elective class costs
additional tuition of $750; now there is a monetary cost to taking History of Jazz.
Is the opportunity cost of taking that course something separate from that monetary cost?
Well, consider two cases. First, suppose that taking Intro to Computer
Graphics also costs $750. In this case, you would have to spend that $750 no matter which class you take. So what you give up to take the History of Jazz class
is still the computer graphics class, period—you would have to spend that $750
7
The real cost of an item is its
opportunity cost: what you must
give up in order to get it.
8
PA R T 1
W H AT I S E C O N O M I C S ?
either way. But suppose there isn’t any fee for the computer graphics class. In
that case, what you give up to take the jazz class is the benefit from the computer
graphics class plus the benefit you could have gained from spending the $750 on
other things.
Either way, the real cost of taking your preferred class is what you must give
up to get it. As you expand the set of decisions that underlie each choice—whether
to take an elective or not, whether to finish this term or not, whether to drop out
or not—you’ll realize that all costs are ultimately opportunity costs.
Sometimes the money you have to pay for something is a good indication of
its opportunity cost. But many times it is not.
One very important example of how poorly monetary cost can indicate opportunity cost is the cost of attending college. Tuition and housing are major monetary expenses for most students; but even if these things were free, attending college would still be an expensive proposition because most college students, if they
were not in college, would have a job. That is, by going to college, students forgo
the income they could have earned if they had worked instead. This means that
the opportunity cost of attending college is what you pay for tuition and housing
plus the forgone income you would have earned in a job.
It’s easy to see that the opportunity cost of going to college is especially high
for people who could be earning a lot during what would otherwise have been
their college years. That is why star athletes like LeBron James and entrepreneurs
like Mark Zuckerberg, founder of Facebook, often skip or drop out of college.
AP Photo/Jeff Chiu
Principle #3: “How Much” Is a Decision at the Margin
Mark Zuckerberg understood the
concept of opportunity cost.
You make a trade-off when you
compare the costs with the benefits
of doing something.
Some important decisions involve an “either–or” choice—for example, you decide
either to go to college or to begin working; you decide either to take economics or to
take something else. But other important decisions involve “how much” choices—
for example, if you are taking both economics and chemistry this semester, you
must decide how much time to spend studying for each. When it comes to understanding “how much” decisions, economics has an important insight to offer:
“how much” is a decision made at the margin.
Suppose you are taking both economics and chemistry. And suppose you are
a pre-med student, so your grade in chemistry matters more to you than your
grade in economics. Does that therefore imply that you should spend all your
study time on chemistry and wing it on the economics exam? Probably not; even
if you think your chemistry grade is more important, you should put some effort
into studying economics.
Spending more time studying chemistry involves a benefit (a higher expected
grade in that course) and a cost (you could have spent that time doing something
else, such as studying to get a higher grade in economics). That is, your decision
involves a trade-off—a comparison of costs and benefits.
How do you decide this kind of “how much” question? The typical answer is
that you make the decision a bit at a time, by asking how you should spend the
next hour. Say both exams are on the same day, and the night before you spend
time reviewing your notes for both courses. At 6:00 p.m., you decide that it’s a good
idea to spend at least an hour on each course. At 8:00 p.m., you decide you’d better
spend another hour on each course. At 10:00 p.m., you are getting tired and figure
you have one more hour to study before bed—chemistry or economics? If you are
pre-med, it’s likely to be chemistry; if you are pre-MBA, it’s likely to be economics.
Note how you’ve made the decision to allocate your time: at each point the
question is whether or not to spend one more hour on either course. And in deciding whether to spend another hour studying for chemistry, you weigh the costs
(an hour forgone of studying for economics or an hour forgone of sleeping) versus
the benefits (a likely increase in your chemistry grade). As long as the benefit of
studying chemistry for one more hour outweighs the cost, you should choose to
study for that additional hour.
CHAPTER 1
Decisions of this type—whether to do a bit more or a bit less of an activity,
like what to do with your next hour, your next dollar, and so on—are marginal
decisions. This brings us to our third principle of individual choice:
“How much” decisions require making trade-offs at the margin: comparing the costs and benefits of doing a little bit more of an activity
versus doing a little bit less.
The study of such decisions is known as marginal analysis. Many of the
questions that we face in economics—as well as in real life—involve marginal
analysis: How many workers should I hire in my shop? At what mileage should I
change the oil in my car? What is an acceptable rate of negative side effects from
a new medicine? Marginal analysis plays a central role in economics because it is
the key to deciding “how much” of an activity to do.
Principle #4: People Usually Respond to Incentives,
Exploiting Opportunities to Make Themselves Better Off
One day, while listening to the morning financial news, the authors heard a great
tip about how to park cheaply in Manhattan. Garages in the Wall Street area
charge as much as $30 per day. But according to this news report, some people
had found a better way: instead of parking in a garage, they had their oil changed
at the Manhattan Jiffy Lube, where it costs $19.95 to change your oil—and they
keep your car all day!
It’s a great story, but unfortunately it turned out not to be true—in fact, there
is no Jiffy Lube in Manhattan. But if there were, you can be sure there would be
a lot of oil changes there. Why? Because when people are offered opportunities
to make themselves better off, they normally take them—and if they could find a
way to park their car all day for $19.95 rather than $30, they would.
In this example economists say that people are responding to an incentive—
an opportunity to make themselves better off. We can now state our fourth principle of individual choice:
People usually respond to incentives, exploiting opportunities to
make themselves better off.
When you try to predict how individuals will behave in an economic situation,
it is a very good bet that they will respond to incentives—that is, exploit opportunities to make themselves better off. Furthermore, individuals will continue to
exploit these opportunities until they have been fully exhausted. If there really
were a Manhattan Jiffy Lube and an oil change really were a cheap way to park
your car, we can safely predict that before long the waiting list for oil changes
would be weeks, if not months.
In fact, the principle that people will exploit opportunities to make themselves
better off is the basis of all predictions by economists about individual behavior.
If the earnings of those who get MBAs soar while the earnings of those who
get law degrees decline, we can expect more students to go to business school
and fewer to go to law school. If the price of gasoline rises and stays high for an
extended period of time, we can expect people to buy smaller cars with higher
gas mileage—making themselves better off in the presence of higher gas prices
by driving more fuel-efficient cars.
One last point: economists tend to be skeptical of any attempt to change
people’s behavior that doesn’t change their incentives. For example, a plan that
calls on manufacturers to reduce pollution voluntarily probably won’t be effective
because it hasn’t changed manufacturers’ incentives. In contrast, a plan that gives
them a financial reward to reduce pollution is a lot more likely to work because
it has changed their incentives.
FIRST PRINCIPLES
9
Decisions about whether to do a
bit more or a bit less of an activity
are marginal decisions. The
study of such decisions is known as
marginal analysis.
An incentive is anything that offers
rewards to people who change their
behavior.
W H AT I S E C O N O M I C S ?
Cashing In At School
FOR INQUIRING MINDS
The true reward for learning is, of
course, the learning itself. Many students, however, struggle with their motivation to study and work hard. Teachers
and policy makers have been particularly
challenged to help students from disadvantaged backgrounds, who often have
poor school attendance, high dropout
rates, and low standardized test scores.
Two studies, a 2009 study by Harvard
economist Roland Fryer Jr. and a 2011
study by University of Chicago economist
Steve Levitt along with others, found that
monetary incentives—cash rewards—
could improve students’ academic
performance in schools in economically
disadvantaged areas. How cash incentives work, however, is both surprising
and predictable.
In the Fryer study, research was conducted in four different school districts,
employing a different set of incentives
and a different measure of performance in each. In New York, students
were paid according to their scores on
standardized tests; in Chicago, they
were paid according to their grades;
in Washington, D.C., they were paid
according to attendance and good
behavior as well as their grades; in
Dallas, second-graders were paid each
time they read a book.
Fryer evaluated the results by comparing the performance of students who
were in the program to other students in
the same school who were not.
In New York, the program had no
perceptible effect on test scores. In
Chicago, students in the program got
better grades and attended class more.
In Washington, the program boosted
the outcomes of the kids who are normally the hardest to reach, those with
serious behavioral problems, raising
their test scores by an amount equivalent to attending five extra months of
school.
The most dramatic results occurred
in Dallas, where students significantly
boosted their reading-comprehension
test scores; results continued into the
next year, after the cash rewards had
ended.
So what explains the various results?
To motivate students with cash
rewards, Fryer found that students had
to believe that they could have a significant effect on the performance measure. So in Chicago, Washington, and
Dallas—where students had a significant
amount of control over outcomes such
as grades, attendance, behavior, and
the number of books read—the program
produced significant results.
But because New York students had
little idea how to affect their score on
a standardized test, the prospect of
a reward had little influence on their
behavior. Also, the timing of the reward
matters: a $1 reward has more effect on
behavior if performance is measured at
shorter intervals and the reward is delivered soon after.
The Levitt study, involving 7,000 students in the Chicago area, confirmed
these results: monetary incentives lead
to an increase in standardized test
scores equivalent to five or six months
of studying for the test. In addition, the
Levitt survey found that offering more
money ($20) resulted in significantly
higher scores than offering less ($10).
Cash incentives have been shown to
improve student performance.
And, like Fryer, Levitt and his co-authors
found that delaying the reward to a
month after the test had no impact on
scores.
These two experiments reveal critical
insights about how to motivate behavior with incentives. How incentives are
designed is very important: the relationship between effort and outcome, as
well as the speed of reward, matters a
lot. Moreover, the design of incentives
may depend quite a lot on the characteristics of the people you are trying to
motivate: what motivates a student from
an economically privileged background
may not motivate a student from an
economically disadvantaged one.
Fryer’s insights give teachers and
policy makers an important new tool for
helping disadvantaged students succeed in school.
•
So are we ready to do economics? Not yet—because most of the interesting
things that happen in the economy are the result not merely of individual choices
but of the way in which individual choices interact.
in Action
RLD VIE
O
W
s
ECONOMICS
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Blend Images/Superstock
10
Boy or Girl? It Depends on the Cost
O
ne fact about China is indisputable: it’s a big country with lots of people.
As of 2012, the population of China was 1,354,040,000. That’s right: over
one billion three hundred and fifty million.
In 1978, the government of China introduced the “one-child policy” to
address the economic and demographic challenges presented by China’s large
population. China was very, very poor in 1978, and its leaders worried that the
country could not afford to adequately educate and care for its growing population. The average Chinese woman in the 1970s was giving birth to more than five
children during her lifetime. So the government restricted most couples, particularly those in urban areas, to one child, imposing penalties on those who defied
the mandate. As a result, by 2011 the average number of births for a woman in
China was only 1.6.
But the one-child policy had an unfortunate unintended consequence.
Because China is an overwhelmingly rural country and sons can perform the
manual labor of farming, families had a strong preference for sons over daughters. In addition, tradition dictates that brides become part of their husbands’
families and that sons take care of their elderly parents. As a result of the onechild policy, China soon had too many “unwanted girls.” Some were given up for
adoption abroad, but many simply “disappeared” during the first year of life, the
victims of neglect and mistreatment.
India, another highly rural poor country with high demographic pressures,
also has a significant problem with “disappearing girls.” In 1990, Amartya Sen,
an Indian-born British economist who would go on to win the Nobel Prize in
1998, estimated that there were up to 100 million “missing women” in Asia. (The
exact figure is in dispute, but it is clear that Sen identified a real and pervasive
problem.)
Demographers have recently noted a distinct turn of events in China, which is
quickly urbanizing. In all but one of the provinces with urban centers, the gender
imbalance between boys and girls peaked in 1995 and has steadily fallen toward
the biologically natural ratio since then.
Many believe that the source of the change is China’s strong economic growth
and increasing urbanization. As people move to cities to take advantage of job
growth there, they don’t need sons to work the fields. Moreover, land prices in
Chinese cities are skyrocketing, making the custom of parents buying an apartment for a son before he can marry unaffordable for many.
To be sure, sons are still preferred in the rural areas. But as a sure mark of
how times have changed, websites have popped up advising couples on how to
have a girl rather than a boy.
Check Your Understanding
FIRST PRINCIPLES
11
Tan Ming Tung/Getty Images
CHAPTER 1
The cost of China’s “one-child
policy” was a generation of “disappeared” daughters—a phenomenon
that itself is disappearing as
economic conditions change.
Quick Review
• All economic activities involve
individual choice.
• People must make choices
because resources are scarce.
• The real cost of something is
its opportunity cost—what you
must give up to get it. All costs are
opportunity costs. Monetary costs
are sometimes a good indicator of
opportunity costs, but not always.
• Many choices involve not
1-1
1. Explain how each of the following situations illustrates one of the four principles
of individual choice.
a. You are on your third trip to a restaurant’s all-you-can-eat dessert buffet and
are feeling very full. Although it would cost you no additional money, you forgo
a slice of coconut cream pie but have a slice of chocolate cake.
b. Even if there were more resources in the world, there would still be scarcity.
c. Different teaching assistants teach several Economics 101 tutorials. Those
taught by the teaching assistants with the best reputations fill up quickly, with
spaces left unfilled in the ones taught by assistants with poor reputations.
d. To decide how many hours per week to exercise, you compare the health benefits of one more hour of exercise to the effect on your grades of one fewer hour
spent studying.
2. You make $45,000 per year at your current job with Whiz Kids Consultants. You
are considering a job offer from Brainiacs, Inc., that will pay you $50,000 per year.
Which of the following are elements of the opportunity cost of accepting the new
job at Brainiacs, Inc.?
a. The increased time spent commuting to your new job
b. The $45,000 salary from your old job
c. The more spacious office at your new job
Solutions appear at back of book.
whether to do something but how
much of it to do. “How much”
choices call for making a tradeoff at the margin. The study of
marginal decisions is known as
marginal analysis.
• Because people usually exploit
opportunities to make themselves
better off, incentives can change
people’s behavior.
12
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W H AT I S E C O N O M I C S ?
Interaction: How Economies Work
As we learned in the Introduction, an economy is a system for coordinating the
productive activities of many people. In a market economy like we live in, coordination takes place without any coordinator: each individual makes his or her
own choices.
Yet those choices are by no means independent of one another: each individual’s opportunities, and hence choices, depend to a large extent on the choices
made by other people. So to understand how a market economy behaves, we have
to examine this interaction in which my choices affect your choices, and vice
versa.
When studying economic interaction, we quickly learn that the end result of
individual choices may be quite different from what any one individual intends.
For example, over the past century farmers in the United States have eagerly
adopted new farming techniques and crop strains that have reduced their costs
and increased their yields. Clearly, it’s in the interest of each farmer to keep up
with the latest farming techniques.
But the end result of each farmer trying to increase his or her own income
has actually been to drive many farmers out of business. Because American farmers have been so successful at producing larger yields, agricultural prices have
steadily fallen. These falling prices have reduced the incomes of many farmers,
and as a result fewer people find farming worth doing. That is, an individual
farmer who plants a better variety of corn is better off; but when
The Principles of the Interaction
TABLE 1-2
many farmers plant a better variety of corn, the result may be to
of Individual Choices
make farmers as a group worse off.
5. There are gains from trade.
A farmer who plants a new, more productive corn variety
6. Because people respond to incentives, markets move
doesn’t just grow more corn. Such a farmer also affects the
toward equilibrium.
market for corn through the increased yields attained, with
7. Resources should be used as efficiently as possible
consequences that will be felt by other farmers, consumers, and
to achieve society’s goals.
beyond.
8. Because people usually exploit gains from trade,
Just as there are four economic principles that underlie indimarkets usually lead to efficiency.
vidual choice, there are five principles underlying the economics
9. When markets don’t achieve efficiency, government
of interaction. These principles are summarized in Table 1-2 and
intervention can improve society’s welfare.
we will now examine each of them more closely.
Principle #5: There Are Gains from Trade
Interaction of choices—my choices
affect your choices, and vice
versa—is a feature of most economic
situations. The results of this
interaction are often quite different
from what the individuals intend.
In a market economy, individuals
engage in trade: they provide goods
and services to others and receive
goods and services in return.
There are gains from trade:
people can get more of what they
want through trade than they could
if they tried to be self-sufficient.
This increase in output is due
to specialization: each person
specializes in the task that he or she
is good at performing.
Why do the choices I make interact with the choices you make? A family could try
to take care of all its own needs—growing its own food, sewing its own clothing,
providing itself with entertainment, writing its own economics textbooks. But
trying to live that way would be very hard.
The key to a much better standard of living for everyone is trade, in which people divide tasks among themselves and each person provides a good or service that
other people want in return for different goods and services that he or she wants.
The reason we have an economy, not many self-sufficient individuals, is that
there are gains from trade: by dividing tasks and trading, two people (or 6 billion people) can each get more of what they want than they could get by being
self-sufficient. This leads us to our fifth principle:
There are gains from trade.
Gains from trade arise from this division of tasks, which economists call
specialization—a situation in which different people each engage in a different
task, specializing in those tasks that they are good at performing. The advantages
of specialization, and the resulting gains from trade, were the starting point for
Adam Smith’s 1776 book The Wealth of Nations, which many regard as the beginning of economics as a discipline.
FIRST PRINCIPLES
13
Smith’s book begins with a description of an eighteenthcentury pin factory where, rather than each of the 10 workers making a pin from start to finish, each worker specialized in one of the many steps in pin-making:
One man draws out the wire, another straights it, a third
cuts it, a fourth points it, a fifth grinds it at the top for
receiving the head; to make the head requires two or
three distinct operations; to put it on, is a particular
business, to whiten the pins is another; it is even a trade
by itself to put them into the paper; and the important
business of making a pin is, in this manner, divided
into about eighteen distinct operations. . . . Those ten
persons, therefore, could make among them upwards
“I hunt and she gathers—otherwise we
of forty-eight thousand pins in a day. But if they had all
couldn’t make ends meet.”
wrought separately and independently, and without any
of them having been educated to this particular business, they certainly
could not each of them have made twenty, perhaps not one pin a day. . . .
The same principle applies when we look at how people divide tasks among
themselves and trade in an economy. The economy, as a whole, can produce more
when each person specializes in a task and trades with others.
The benefits of specialization are the reason a person typically chooses only
one career. It takes many years of study and experience to become a doctor or to
become a commercial airline pilot. Many doctors might well have had the potential to become excellent pilots, and vice versa; but it is very unlikely that anyone
who decided to pursue both careers would be as good a pilot or as good a doctor
as someone who decided at the beginning to specialize in that field. So it is to
everyone’s advantage that individuals specialize in their career choices.
Markets are what allow a doctor and a pilot to specialize in their own fields.
Because markets for commercial flights and for doctors’ services exist, a doctor
is assured that she can find a flight and a pilot is assured that he can find a doctor. As long as individuals know that they can find the goods and services they
want in the market, they are willing to forgo self-sufficiency and to specialize.
But what assures people that markets will deliver what they want? The answer to
that question leads us to our second principle of how individual choices interact.
Principle #6: Markets Move Toward Equilibrium
It’s a busy afternoon at the supermarket; there are long lines at the checkout
counters. Then one of the previously closed cash registers opens. What happens?
The first thing, of course, is a rush to that register. After a couple of minutes,
however, things will have settled down; shoppers will have rearranged themselves
so that the line at the newly opened register is about the same length as the lines
at all the other registers.
How do we know that? We know from our fourth principle that people will
exploit opportunities to make themselves better off. This means that people will
rush to the newly opened register in order to save time standing in line. And
things will settle down when shoppers can no longer improve their position by
switching lines—that is, when the opportunities to make themselves better off
have all been exploited.
A story about supermarket checkout lines may seem to have little to do with
how individual choices interact, but in fact it illustrates an important principle.
A situation in which individuals cannot make themselves better off by doing
something different—the situation in which all the checkout lines are the same
length—is what economists call an equilibrium. An economic situation is in
equilibrium when no individual would be better off doing something different.
An economic situation is in
equilibrium when no individual
would be better off doing something
different.
© The New Yorker Collection 1991 Ed Frascino from
cartoonbank.com. All Rights Reserved.
CHAPTER 1
W H AT I S E C O N O M I C S ?
Why do people in America drive on the
right side of the road? Of course, it’s
the law. But long before it was the law, it
was an equilibrium.
Before there were formal traffic laws,
there were informal “rules of the road,”
practices that everyone expected everyone else to follow. These rules included
an understanding that people would
normally keep to one side of the road. In
some places, such as England, the rule
was to keep to the left; in others, such
as France, it was to keep to the right.
Why would some places choose the
right and others, the left? That’s not
completely clear, although it may have
depended on the dominant form of
traffic. Men riding horses and carrying
swords on their left hip preferred to ride
on the left (think about getting on or off
the horse, and you’ll see why). On the
other hand, right-handed people walking
W
Choosing Sides
FOR INQUIRING MINDS
RLD VIE
O
but leading horses apparently preferred
to walk on the right.
In any case, once a rule of the road was
established, there were strong incentives
for each individual to stay on the “usual”
side of the road: those who didn’t would
keep colliding with oncoming traffic.
So once established, the rule of the
road would be self-enforcing—that is,
it would be an equilibrium. Nowadays,
of course, which side you drive on is
determined by law; some countries have
even changed sides. In 2009, the island
nation of Samoa switched from right to
left to conform with the left-side driving
in other South Pacific countries.
But what about pedestrians? There are
no laws—but there are informal rules. In the
United States, urban pedestrians normally
keep to the right. But if you should happen
to visit a country where people drive on the
left, watch out: people who drive on the left
©Curious Lens-Stock Photos/Alamy
PA R T 1
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14
Before traffic laws, the rule of the road was
an equilibrium.
also typically walk on the left. So when in
a foreign country, do as the locals do. You
won’t be arrested if you walk on the right,
but you will be worse off than if you accept
the equilibium and walk on the left.
•
Recall the story about the mythical Jiffy Lube, where it was supposedly cheaper
to leave your car for an oil change than to pay for parking. If the opportunity had
really existed and people were still paying $30 to park in garages, the situation
would not have been an equilibrium. And that should have been a giveaway that the
story couldn’t be true. In reality, people would have seized an opportunity to park
cheaply, just as they seize opportunities to save time at the checkout line. And in
so doing they would have eliminated the opportunity! Either it would have become
very hard to get an appointment for an oil change or the price of a lube job would
have increased to the point that it was no longer an attractive option (unless you
really needed a lube job). This brings us to our sixth principle:
Because people respond to incentives, markets move toward equilibrium.
As we will see, markets usually reach equilibrium via changes in prices, which rise
or fall until no opportunities for individuals to make themselves better off remain.
The concept of equilibrium is extremely helpful in understanding economic
interactions because it provides a way of cutting through the sometimes complex
details of those interactions. To understand what happens when a new line is
opened at a supermarket, you don’t need to worry about exactly how shoppers
rearrange themselves, who moves ahead of whom, which register just opened,
and so on. What you need to know is that any time there is a change, the situation
will move to an equilibrium.
The fact that markets move toward equilibrium is why we can depend on them
to work in a predictable way. In fact, we can trust markets to supply us with the
essentials of life. For example, people who live in big cities can be sure that the
supermarket shelves will always be fully stocked. Why? Because if some merchants who distribute food didn’t make deliveries, a big profit opportunity would
be created for any merchant who did—and there would be a rush to supply food,
just like the rush to a newly opened cash register.
So the market ensures that food will always be available for city dwellers. And,
returning to our fifth principle, this allows city dwellers to be city dwellers—to specialize in doing city jobs rather than living on farms and growing their own food.
CHAPTER 1
FIRST PRINCIPLES
15
A market economy, as we have seen, allows people to achieve gains from trade.
But how do we know how well such an economy is doing? The next principle gives
us a standard to use in evaluating an economy’s performance.
An economy is efficient if it takes all
opportunities to make some people
better off without making other
people worse off.
Principle #7: Resources Should Be Used Efficiently
to Achieve Society’s Goals
Equity means that everyone gets his
or her fair share. Since people can
disagree about what’s “fair,” equity
isn’t as well defined a concept as
efficiency.
Suppose you are taking a course in which the classroom is too small for the number of students—many people are forced to stand or sit on the floor—despite the
fact that large, empty classrooms are available nearby. You would say, correctly,
that this is no way to run a college. Economists would call this an inefficient use
of resources. But if an inefficient use of resources is undesirable, just what does
it mean to use resources efficiently?
You might imagine that the efficient use of resources has something to do with
money, maybe that it is measured in dollars-and-cents terms. But in economics,
as in life, money is only a means to other ends. The measure that economists
really care about is not money but people’s happiness or welfare. Economists say
that an economy’s resources are used efficiently when they are used in a way that
has fully exploited all opportunities to make everyone better off. To put it another
way, an economy is efficient if it takes all opportunities to make some people
better off without making other people worse off.
In our classroom example, there clearly was a way to make everyone better off—
moving the class to a larger room would make people in the class better off without
hurting anyone else in the college. Assigning the course to the smaller classroom
was an inefficient use of the college’s resources, whereas assigning the course to the
larger classroom would have been an efficient use of the college’s resources.
When an economy is efficient, it is producing the maximum gains from trade
possible given the resources available. Why? Because there is no way to rearrange how resources are used in a way that can make everyone better off. When
an economy is efficient, one person can be made better off by rearranging how
resources are used only by making someone else worse off.
In our classroom example, if all larger classrooms were already occupied, the
college would have been run in an efficient way: your class could be made better
off by moving to a larger classroom only by making people in the larger classroom worse off by making them move to a smaller classroom.
We can now state our seventh principle:
Should economic policy makers always strive to achieve economic efficiency?
Well, not quite, because efficiency is only a means to achieving society’s goals.
Sometimes efficiency may conflict with a goal that society has deemed worthwhile to achieve. For example, in most societies, people also care about issues
of fairness, or equity. And there is typically a trade-off between equity and efficiency: policies that promote equity often come at a cost of decreased efficiency
in the economy, and vice versa.
To see this, consider the case of disabled-designated parking spaces in public
parking lots. Many people have difficulty walking due to age or disability, so it seems
only fair to assign closer parking spaces specifically for their use. You may have
noticed, however, that a certain amount of inefficiency is involved. To make sure that
there is always a parking space available should a disabled person want one, there are
typically more such spaces available than there are disabled people who want one. As
a result, desirable parking spaces are unused. (And the temptation for nondisabled
people to use them is so great that we must be dissuaded by fear of getting a ticket.)
So, short of hiring parking valets to allocate spaces, there is a conflict between
equity, making life “fairer” for disabled people, and efficiency, making sure that
Construction Photography/CorbIs
Resources should be used as efficiently as possible to achieve society’s
goals.
Sometimes equity trumps efficiency.
16
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all opportunities to make people better off have been fully exploited by never letting close-in parking spaces go unused.
Exactly how far policy makers should go in promoting equity over efficiency
is a difficult question that goes to the heart of the political process. As such, it
is not a question that economists can answer. What is important for economists,
however, is always to seek to use the economy’s resources as efficiently as possible
in the pursuit of society’s goals, whatever those goals may be.
Principle #8: Markets Usually Lead to Efficiency
No branch of the U.S. government is entrusted with ensuring the general economic
efficiency of our market economy—we don’t have agents who go around making
sure that brain surgeons aren’t plowing fields or that Minnesota farmers aren’t trying to grow oranges. The government doesn’t need to enforce the efficient use of
resources, because in most cases the invisible hand does the job.
The incentives built into a market economy ensure that resources are usually
put to good use and that opportunities to make people better off are not wasted.
If a college were known for its habit of crowding students into small classrooms
while large classrooms went unused, it would soon find its enrollment dropping,
putting the jobs of its administrators at risk. The “market” for college students
would respond in a way that induced administrators to run the college efficiently.
A detailed explanation of why markets are usually very good at making sure
that resources are used well will have to wait until we have studied how markets
actually work. But the most basic reason is that in a market economy, in which
individuals are free to choose what to consume and what to produce, people normally take opportunities for mutual gain—that is, gains from trade.
If there is a way in which some people can be made better off, people will usually be able to take advantage of that opportunity. And that is exactly what defines
efficiency: all the opportunities to make some people better off without making
other people worse off have been exploited. This gives rise to our eighth principle:
Because people usually exploit gains from trade, markets usually lead
to efficiency.
However, there are exceptions to this principle that markets are generally
efficient. In cases of market failure, the individual pursuit of self-interest found in
markets makes society worse off—that is, the market outcome is inefficient. And,
as we will see in examining the next principle, when markets fail, government
intervention can help. But short of instances of market failure, the general rule is
that markets are a remarkably good way of organizing an economy.
Principle #9: When Markets Don’t Achieve Efficiency,
Government Intervention Can Improve Society’s Welfare
Let’s recall from the Introduction the nature of the market failure caused by traffic congestion—a commuter driving to work has no incentive to take into account
the cost that his or her action inflicts on other drivers in the form of increased
traffic congestion.
There are several possible remedies to this situation; examples include charging road tolls, subsidizing the cost of public transportation, and taxing sales of
gasoline to individual drivers. All these remedies work by changing the incentives
of would-be drivers, motivating them to drive less and use alternative transportation. But they also share another feature: each relies on government intervention
in the market. This brings us to our ninth principle:
When markets don’t achieve efficiency, government intervention can
improve society’s welfare.
CHAPTER 1
FIRST PRINCIPLES
17
That is, when markets go wrong, an appropriately designed government policy
can sometimes move society closer to an efficient outcome by changing how society’s resources are used.
An important branch of economics is devoted to studying why markets fail
and what policies should be adopted to improve social welfare. We will study
these problems and their remedies in depth in later chapters, but, briefly, there
are three principal ways in which they fail:
• Individual actions have side effects that are not properly taken into account by
the market. An example is an action that causes pollution.
• One party prevents mutually beneficial trades from occurring in an attempt to
capture a greater share of resources for itself. An example is a drug company
that prices a drug higher than the cost of producing it, making it unaffordable
for some people who would benefit from it.
• Some goods, by their very nature, are unsuited for efficient management by
markets. An example of such a good is air traffic control.
An important part of your education in economics is learning to identify not
just when markets work but also when they don’t work, and to judge what government policies are appropriate in each situation.
s
ECONOMICS
in Action
Restoring Equilibrium on the Freeways
Glowimages/Getty Images
W
hen a powerful earthquake struck the Los Angeles area back in 1994,
it caused several freeway bridges to collapse and thereby disrupted
the normal commuting routes of hundreds of thousands of drivers.
The events that followed offer a particularly clear example of interdependent
decision making—in this case, the decisions of commuters about how to get to
work.
In the immediate aftermath of the earthquake, there was
great concern about the impact on traffic, since motorists
would now have to crowd onto alternative routes or detour
around the blockages by using city streets. Public officials
and news programs warned commuters to expect massive
delays and urged them to avoid unnecessary travel, reschedule their work to commute before or after the rush, or use
mass transit.
These warnings were unexpectedly effective. In fact, so
many people heeded them that in the first few days following
the quake, those who maintained their regular commuting
routine actually found the drive to and from work faster than
before.
Of course, this situation could not last. As word spread
that traffic was relatively light, people abandoned their less
Witness equilibrium in action on a Los Angeles freeway.
convenient new commuting methods and reverted to their
cars—and traffic got steadily worse. Within a few weeks
after the quake, serious traffic jams had appeared. After a few more weeks,
however, the situation stabilized: the reality of worse-than-usual congestion
discouraged enough drivers to prevent the nightmare of citywide gridlock from
materializing. Los Angeles traffic, in short, had settled into a new equilibrium,
in which each commuter was making the best choice he or she could, given
what everyone else was doing.
18
PA R T 1
W H AT I S E C O N O M I C S ?
Quick Review
• Most economic situations
involve the interaction of choices,
sometimes with unintended
results. In a market economy,
interaction occurs via trade
between individuals.
• Individuals trade because there
are gains from trade, which arise
from specialization. Markets
usually move toward equilibrium
because people exploit gains from
trade.
• To achieve society’s goals,
the use of resources should be
efficient. But equity, as well as
efficiency, may be desirable in an
economy. There is often a tradeoff between equity and efficiency.
• Except for certain well-defined
exceptions, markets are normally
efficient. When markets fail to
achieve efficiency, government
intervention can improve society’s
welfare.
This was not, by the way, the end of the story: fears that traffic would strangle
the city led local authorities to repair the roads with record speed. Within only 18
months after the quake, all the freeways were back to normal, ready for the next one.
Check Your Understanding
1-2
1. Explain how each of the following situations illustrates one of the five principles of
interaction.
a. Using eBay any student who wants to sell a used textbook for at least $30 is able
to sell it to someone who is willing to pay $30.
b. At a college tutoring co-op, students can arrange to provide tutoring in subjects
they are good in (like economics) in return for receiving tutoring in subjects
they are poor in (like philosophy).
c. The local municipality imposes a law that requires bars and nightclubs near
residential areas to keep their noise levels below a certain threshold.
d. To provide better care for low-income patients, the local municipality has
decided to close some underutilized neighborhood clinics and shift funds to the
main hospital.
e. On eBay books of a given title with approximately the same level of wear and
tear sell for about the same price.
2. Which of the following describes an equilibrium situation? Which does not?
Explain your answer.
a. The restaurants across the street from the university dining hall serve bettertasting and cheaper meals than those served at the university dining hall. The
vast majority of students continue to eat at the dining hall.
b. You currently take the subway to work. Although taking the bus is cheaper, the ride
takes longer. So you are willing to pay the higher subway fare in order to save time.
Solutions appear at back of book.
Economy-Wide Interactions
As mentioned in the Introduction, the economy as a whole has its ups and downs.
For example, business in America’s shopping malls was depressed in 2008, because
the economy was in a recession. While the economy had begun to
The Principles of EconomyTABLE 1-3
recover in 2009, the effects of the downturn were still being felt—not
Wide Interactions
until May 2014 did the number of Americans employed recover to its
10. One person’s spending is another person’s income.
pre-recession level.
11. Overall spending sometimes gets out of line with the
To understand recessions and recoveries, we need to undereconomy’s productive capacity.
stand economy-wide interactions, and understanding the big
12. Government policies can change spending.
picture of the economy requires three more economic principles,
which are summarized in Table 1-3.
Principle #10: One Person’s Spending Is Another
Person’s Income
Between 2005 and 2011, home construction in America plunged more than 60%
because builders found it increasingly hard to make sales. At first the damage
was mainly limited to the construction industry. But over time the slump spread
into just about every part of the economy, with consumer spending falling across
the board.
But why should a fall in home construction mean empty stores in the shopping
malls? After all, malls are places where families, not builders, do their shopping.
The answer is that lower spending on construction led to lower incomes
throughout the economy; people who had been employed either directly in construction, producing goods and services builders need (like wallboard), or in producing goods and services new homeowners need (like new furniture), either lost
CHAPTER 1
their jobs or were forced to take pay cuts. And as incomes fell, so did spending by
consumers. This example illustrates our tenth principle:
One person’s spending is another person’s income.
In a market economy, people make a living selling things—including their
labor—to other people. If some group in the economy decides, for whatever reason, to spend more, the income of other groups will rise. If some group decides
to spend less, the income of other groups will fall.
Because one person’s spending is another person’s income, a chain reaction of
changes in spending behavior tends to have repercussions that spread through the
economy. For example, a cut in business investment spending, like the one that happened in 2008, leads to reduced family incomes; families respond by reducing consumer spending; this leads to another round of income cuts; and so on. These repercussions play an important role in our understanding of recessions and recoveries.
Principle #11: Overall Spending Sometimes Gets Out
of Line with the Economy’s Productive Capacity
Macroeconomics emerged as a separate branch of economics in the 1930s, when
a collapse of consumer and business spending, a crisis in the banking industry,
and other factors led to a plunge in overall spending. This plunge in spending, in
turn, led to a period of very high unemployment known as the Great Depression.
The lesson economists learned from the troubles of the 1930s is that overall
spending—the amount of goods and services that consumers and businesses want
to buy—sometimes doesn’t match the amount of goods and services the economy
is capable of producing. In the 1930s, spending fell far short of what was needed
to keep American workers employed, and the result was a severe economic slump.
In fact, shortfalls in spending are responsible for most, though not all, recessions.
It’s also possible for overall spending to be too high. In that case, the economy
experiences inflation, a rise in prices throughout the economy. This rise in prices
occurs because when the amount that people want to buy outstrips the supply, producers can raise their prices and still find willing customers. Taking account of both
shortfalls in spending and excesses in spending brings us to our eleventh principle:
Overall spending sometimes gets out of line with the economy’s productive capacity.
Principle #12: Government Policies Can
Change Spending
Overall spending sometimes gets out of line with the economy’s productive capacity. But can anything be done about that? Yes—which leads to our twelfth and
last principle:
Government policies can change spending.
In fact, government policies can dramatically affect spending.
For one thing, the government itself does a lot of spending on everything
from military equipment to education—and it can choose to do more or less. The
government can also vary how much it collects from the public in taxes, which
in turn affects how much income consumers and businesses have left to spend.
And the government’s control of the quantity of money in circulation, it turns out,
gives it another powerful tool with which to affect total spending. Government
spending, taxes, and control of money are the tools of macro-economic policy.
Modern governments deploy these macroeconomic policy tools in an effort to
manage overall spending in the economy, trying to steer it between the perils of
recession and inflation. These efforts aren’t always successful—recessions still
FIRST PRINCIPLES
19
20
PA R T 1
W H AT I S E C O N O M I C S ?
happen, and so do periods of inflation. But it’s widely believed that aggressive
efforts to sustain spending in 2008 and 2009 helped prevent the financial crisis
of 2008 from turning into a full-blown depression.
s
ECONOMICS
in Action
Adventures in Babysitting
istockphoto
T
As participants in a babysitting
co-op soon discovered, fewer nights
out made everyone worse off.
Quick Review
• In a market economy, one
person’s spending is another
person’s income. As a result,
changes in spending behavior
have repercussions that spread
through the economy.
• Overall spending sometimes
gets out of line with the economy’s
capacity to produce goods and
services. When spending is too
low, the result is a recession.
When spending is too high, it
causes inflation.
• Modern governments use
macroeconomic policy tools to
affect the overall level of spending
in an effort to steer the economy
between recession and inflation.
he website, myarmyonesource.com, which offers advice to army families,
suggests that parents join a babysitting cooperative—an arrangement that
is common in many walks of life. In a babysitting cooperative, a number of
parents exchange babysitting services rather than hire someone to babysit. But how
do these organizations make sure that all members do their fair share of the work?
As myarmyonesource.com explained, “Instead of money, most co-ops exchange
tickets or points. When you need a sitter, you call a friend on the list, and you
pay them with tickets. You earn tickets by babysitting other children within the
co-op.” In other words, a babysitting co-op is a miniature economy in which
people buy and sell babysitting services. And it happens to be a type of economy
that can have macroeconomic problems.
A famous article titled “Monetary Theory and the Great Capitol Hill
Babysitting Co-Op Crisis” described the troubles of a babysitting cooperative that
issued too few tickets. Bear in mind that, on average, people in a babysitting co-op
want to have a reserve of tickets stashed away in case they need to go out several
times before they can replenish their stash by doing some more babysitting.
In this case, because there weren’t that many tickets out there to begin with,
most parents were anxious to add to their reserves by babysitting but reluctant
to run them down by going out. But one parent’s decision to go out was another’s
chance to babysit, so it became difficult to earn tickets. Knowing this, parents
became even more reluctant to use their reserves except on special occasions.
In short, the co-op had fallen into a recession. Recessions in the larger, nonbabysitting economy are a bit more complicated than this, but the troubles of
the Capitol Hill babysitting co-op demonstrate two of our three principles of
economy-wide interactions. One person’s spending is another person’s income:
opportunities to babysit arose only to the extent that other people went out.
An economy can also suffer from too little spending: when not enough people were
willing to go out, everyone was frustrated at the lack of babysitting opportunities.
And what about government policies to change spending? Actually, the Capitol
Hill co-op did that, too. Eventually, it solved its problem by handing out more
tickets, and with increased reserves, people were willing to go out more.
Check Your Understanding
1-3
1. Explain how each of the following examples illustrates one of the three principles
of economy-wide interactions.
a. The White House urged Congress to pass a package of temporary spending
increases and tax cuts in early 2009, a time when employment was plunging and
unemployment soaring.
b. Oil companies are investing heavily in projects that will extract oil from the
“oil sands” of Canada. In Edmonton, Alberta, near the projects, restaurants and
other consumer businesses are booming.
c. I n the mid-2000s, Spain, which was experiencing a big housing boom, also had
the highest inflation rate in Europe.
Solutions appear at back of book.
W
CASE
How Priceline.com Revolutionized
the Travel Industry
RLD VIE
O
W
BUSINESS
©Netphotos/Alamy
I
n 2001 and 2002, the travel industry was in deep trouble. After the terrorist attacks of September 11, 2001, many people simply stopped flying. As the
economy went into a deep slump, airplanes sat empty on the tarmac and the
airlines lost billions of dollars. When several major airlines spiraled toward bankruptcy, Congress passed a $15 billion aid package that was critical in stabilizing
the airline industry.
This was also a particularly difficult time for Priceline.com, the
online travel service. Just four years after its founding, Priceline.
com was in danger of going under. The change in the company’s
fortunes had been dramatic.
In 1999, one year after Priceline.com was formed, investors
were so impressed by its potential for revolutionizing the travel
industry that they valued the company at $9 billion dollars. But
by 2002 investors had taken a decidedly dimmer view of the company, reducing its valuation by 95% to only $425 million.
To make matters worse, Priceline.com was losing several
million dollars a year. Yet the company managed to survive and
thrive; in 2014 it was valued by investors at over $63 billion.
So exactly how did Priceline.com bring such dramatic change
to the travel industry? And what has allowed it to survive and
prosper as a company in the face of dire economic conditions?
Priceline.com’s success lies in its ability to spot exploitable opportunities for itself and its customers. The company understood that when
a plane departs with empty seats or a hotel has empty beds, it bears a cost—the
revenue that would have been earned if that seat or bed had been filled. And
although some travelers like the security of booking their flights and hotels well in
advance and are willing to pay for that, others are quite happy to wait until the last
minute, risking not getting the flight or hotel they want but enjoying a lower price.
Customers specify the price they are willing to pay for a given trip or hotel
location, and then Priceline.com presents them with a list of options from airlines
or hotels that are willing to accept that price, with the price typically declining as
the date of the trip nears.
By bringing airlines and hotels with unsold capacity together with travelers who
are willing to sacrifice some of their preferences for a lower price, Priceline.com
made everyone better off—including itself, since it charged a small commission
for each trade it facilitated.
Priceline.com was also quick on its feet when it saw its market challenged by
newcomers Expedia and Orbitz. In response, it aggressively moved more of its
business toward hotel bookings and into Europe, where the online travel industry was still quite small. Its network was particularly valuable in the European
hotel market, with many more small hotels compared to the U.S. market, which
is dominated by nationwide chains. The efforts paid off, and by 2003 Priceline.
com had turned its first profit.
Priceline.com now operates within a network of more than 295,000 hotels in
over 190 countries. As of 2013, its revenues had grown well over 20% in each of
the previous five years, even growing 34% during the 2008 recession.
Clearly, the travel industry will never be the same again.
QUESTION FOR THOUGHT
1. Explain how each of the twelve principles of economics is illustrated in this
case study.
21
22
PA R T 1
W H AT I S E C O N O M I C S ?
SUMMARY
with one another, the members of an economy can all
be made better off. Specialization—each person specializes in the task he or she is good at—is the source
of gains from trade.
1. All economic analysis is based on a set of basic prin-
ciples that apply to three levels of economic activity.
First, we study how individuals make choices; second,
we study how these choices interact; and third, we
study how the economy functions overall.
9. Because individuals usually respond to incentives,
markets normally move toward equilibrium—
a situation in which no individual can make
himself or herself better off by taking a different
action.
2. Everyone has to make choices about what to do
and what not to do. Individual choice is the basis
of economics—if it doesn’t involve choice, it isn’t
economics.
3. The reason choices must be made is that resources—
10. An economy is efficient if all opportunities to
anything that can be used to produce something
else—are scarce. Individuals are limited in
their choices by money and time; economies are
limited by their supplies of human and natural
resources.
make some people better off without making
other people worse off are taken. Resources
should be used as efficiently as possible to achieve
society’s goals. But efficiency is not the sole way
to evaluate an economy: equity, or fairness, is also
desirable, and there is often a trade-off between
equity and efficiency.
4. Because you must choose among limited alternatives,
the true cost of anything is what you must give up to
get it—all costs are opportunity costs.
11. Markets usually lead to efficiency, with some well-
defined exceptions.
5. Many economic decisions involve questions not of
“whether” but of “how much”—how much to spend
on some good, how much to produce, and so on.
Such decisions must be made by performing a
trade-off at the margin—by comparing the costs and
benefits of doing a bit more or a bit less. Decisions
of this type are called marginal decisions, and the
study of them, marginal analysis, plays a central
role in economics.
6. The study of how people should make decisions is also
a good way to understand actual behavior. Individuals
usually respond to incentives—exploiting opportunities to make themselves better off.
12. When markets fail and do not achieve efficien-
cy, government intervention can improve society’s
welfare.
13. Because people in a market economy earn income
by selling things, including their own labor, one person’s spending is another person’s income. As a result,
changes in spending behavior can spread throughout
the economy.
14. Overall spending in the economy can get out of line
with the economy’s productive capacity. Spending
below the economy’s productive capacity leads to a
recession; spending in excess of the economy’s productive capacity leads to inflation.
7. The next level of economic analysis is the study
of interaction—how my choices depend on your
choices, and vice versa. When individuals interact,
the end result may be different from what anyone
intends.
15. Governments have the ability to strongly affect
overall spending, an ability they use in an effort
to steer the economy between recession and
inflation.
8. Individuals interact because there are gains from
trade: by engaging in the trade of goods and services
KEY TERMS
Individual choice, p. 6
Resource, p. 6
Scarce, p. 6
Opportunity cost, p. 7
Trade-off, p. 8
Marginal decisions, p. 9
Marginal analysis, p. 9
Incentive, p. 9
Interaction, p. 12
Trade, p. 12
Gains from trade, p. 12
Specialization, p. 12
Equilibrium, p. 13
Efficient, p. 15
Equity, p. 15
CHAPTER 1
FIRST PRINCIPLES
23
PROBLEMS
1. In each of the following situations, identify which of the
twelve principles is at work.
a. You choose to shop at the local discount store rather
than paying a higher price for the same merchandise at the local department store.
b. On your spring break trip, your budget is limited to
$35 a day.
c. The student union provides a website on which
departing students can sell items such as used
books, appliances, and furniture rather than
give them away to their roommates as they formerly did.
d. After a hurricane did extensive damage to homes
on the island of St. Crispin, homeowners wanted to
purchase many more building materials and hire
many more workers than were available on the
island. As a result, prices for goods and services rose
dramatically across the board.
e. You buy a used textbook from your roommate. Your
roommate uses the money to buy songs from iTunes.
f. You decide how many cups of coffee to have
when studying the night before an exam by considering how much more work you can do by having another cup versus how jittery it will make
you feel.
g. There is limited lab space available to do the proj-
ect required in Chemistry 101. The lab supervisor
assigns lab time to each student based on when that
student is able to come.
h. You realize that you can graduate a semester early
by forgoing a semester of study abroad.
i. At the student union, there is a bulletin board on
which people advertise used items for sale, such as
bicycles. Once you have adjusted for differences in
quality, all the bikes sell for about the same price.
j. You are better at performing lab experiments, and
your lab partner is better at writing lab reports. So
the two of you agree that you will do all the experiments and she will write up all the reports.
k. State governments mandate that it is illegal to drive
without passing a driving exam.
l. Your parents’ after-tax income has increased
because of a tax cut passed by Congress. They therefore increase your allowance, which you spend on a
spring break vacation.
2. Describe some of the opportunity costs when you
decide to do the following.
a. Attend college instead of taking a job
b. Watch a movie instead of studying for an exam
c. Ride the bus instead of driving your car
3. Liza needs to buy a textbook for the next economics
class. The price at the college bookstore is $65. One
online site offers it for $55 and another site, for $57. All
prices include sales tax. The accompanying table indi-
cates the typical shipping and handling charges for the
textbook ordered online.
Delivery time
Charge
Standard shipping
Shipping method
3–7 days
$3.99
Second-day air
2 business
days
8.98
1 business day
13.98
Next-day air
a. What is the opportunity cost of buying online
instead of at the bookstore? Note that if you buy the
book online, you must wait to get it.
b. Show the relevant choices for this student. What
determines which of these options the student will
choose?
4. Use the concept of opportunity cost to explain the
following.
a. More people choose to get graduate degrees when
the job market is poor.
b. More people choose to do their own home repairs
when the economy is slow and hourly wages are
down.
c. There are more parks in suburban than in urban
areas.
d. Convenience stores, which have higher prices than
supermarkets, cater to busy people.
e. Fewer students enroll in classes that meet before
10:00 A .M.
5. In the following examples, state how you would use the
principle of marginal analysis to make a decision.
a. Deciding how many days to wait before doing your
laundry
b. Deciding how much library research to do before
writing your term paper
c. Deciding how many bags of chips to eat
d. Deciding how many lectures of a class to skip
6. This morning you made the following individual
choices: you bought a bagel and coffee at the local
café, you drove to school in your car during rush hour,
and you typed your roommate’s term paper because
you are a fast typist—in return for which she will do
your laundry for a month. For each of these actions,
describe how your individual choices interacted with
the individual choices made by others. Were other
people left better off or worse off by your choices in
each case?
7. The Hatfield family lives on the east side of the
Hatatoochie River, and the McCoy family lives on the
west side. Each family’s diet consists of fried chicken
and corn-on-the-cob, and each is self-sufficient, raising their own chickens and growing their own corn.
Explain the conditions under which each of the following would be true.
24
PA R T 1
W H AT I S E C O N O M I C S ?
a. The two families are made better off when the
Hatfields specialize in raising chickens, the McCoys
specialize in growing corn, and the two families trade.
b. The two families are made better off when
the McCoys specialize in raising chickens, the
Hatfields specialize in growing corn, and the two
families trade.
8. Which of the following situations describes an equilib-
rium? Which does not? If the situation does not describe
an equilibrium, what would an equilibrium look like?
a. Many people regularly commute from the suburbs
to downtown Pleasantville. Due to traffic congestion,
the trip takes 30 minutes when you travel by highway
but only 15 minutes when you go by side streets.
b. At the intersection of Main and Broadway are two
gas stations. One station charges $3.00 per gallon for
regular gas and the other charges $2.85 per gallon.
Customers can get service immediately at the first
station but must wait in a long line at the second.
c. Every student enrolled in Economics 101 must also
attend a weekly tutorial. This year there are two sections offered: section A and section B, which meet at
the same time in adjoining classrooms and are taught
by equally competent instructors. Section A is overcrowded, with people sitting on the floor and often
unable to see what is written on the board at the
front of the room. Section B has many empty seats.
9. In each of the following cases, explain whether you think
the situation is efficient or not. If it is not efficient, why
not? What actions would make the situation efficient?
a. Electricity is included in the rent at your dorm.
Some residents in your dorm leave lights, computers, and appliances on when they are not in their
rooms.
b. Although they cost the same amount to prepare,
incentive is and what behavior the government wishes
to promote. In each case, why do you think that the
government might wish to change people’s behavior,
rather than allow their actions to be solely determined
by individual choice?
a. A tax of $5 per pack is imposed on cigarettes.
b. The government pays parents $100 when their child
is vaccinated for measles.
c. The government pays college students to tutor chil-
dren from low-income families.
d. The government imposes a tax on the amount of air
pollution that a company discharges.
12. In each of the following situations, explain how govern-
ment intervention could improve society’s welfare by
changing people’s incentives. In what sense is the market going wrong?
a. Pollution from auto emissions has reached
unhealthy levels.
b. Everyone in Woodville would be better off if street-
lights were installed in the town. But no individual
resident is willing to pay for installation of a streetlight in front of his or her house because it is impossible to recoup the cost by charging other residents
for the benefit they receive from it.
13. In 2010, Tim Geithner, Treasury secretary at the time,
published an article defending the administration’s
policies. In it he said, “The recession that began in
late 2007 was extraordinarily severe. But the actions
we took at its height to stimulate the economy helped
arrest the free fall, preventing an even deeper collapse
and putting the economy on the road to recovery.”
Which two of the three principles of economy-wide
interaction are at work in this statement?
14. In August 2007, a sharp downturn in the U.S. housing
spaces available. Some students who need to take
this course to complete their major are unable to get
a space even though others who are taking it as an
elective do get a space.
market reduced the income of many who worked in the
home construction industry. A Wall Street Journal news
article reported that Walmart’s wire-transfer business
was likely to suffer because many construction workers
are Hispanics who regularly send part of their wages back
to relatives in their home countries via Walmart. With this
information, use one of the principles of economy-wide
interaction to trace a chain of links that explains how
reduced spending for U.S. home purchases is likely to
affect the performance of the Mexican economy.
10. Discuss the efficiency and equity implications of each
15. In 2012, Hurricane Sandy caused massive destruction
the cafeteria in your dorm consistently provides too
many dishes that diners don’t like, such as tofu casserole, and too few dishes that diners do like, such
as roast turkey with dressing.
c. The enrollment for a particular course exceeds the
of the following policies. How would you go about balancing the concerns of equity and efficiency in these
areas?
a. The government pays the full tuition for every college student to study whatever subject he or she
wishes.
b. When people lose their jobs, the government pro-
vides unemployment benefits until they find new
ones.
11. Governments often adopt certain policies in order to
promote desired behavior among their citizens. For
each of the following policies, determine what the
to the northeast United States. Tens of thousands of
people lost their homes and possessions. Even those
who weren’t directly affected by the destruction were
hurt because businesses failed or contracted and jobs
dried up. Using one of the principles of economy-wide
interaction, explain how government intervention can
help in this situation.
16. During the Great Depression, food was left to rot
in the fields or fields that had once been actively
cultivated were left fallow. Use one of the principles of
economy-wide interaction to explain how this could
have occurred.
CHAPTER
Economic Models:
Trade-offs and Trade
2
FROM KITTY HAWK TO DREAMLINER
s
What You Will Learn
in This Chapter
Why models—simplified
•representations
of reality—play a
crucial role in economics
Two simple but important
•models:
the production
possibility frontier and
comparative advantage
•
The difference between positive
•economics,
which analyzes
how the economy works, and
normative economics, which
prescribes economic policy
economists agree and
•whyWhen
they sometimes disagree
UPI/Alan Marts/Boeing/Landov
The circular-flow diagram, a
schematic representation of the
economy
The Wright brothers’ model made modern airplanes, including the Dreamliner, possible.
I
n DECEMBER 2009, BOEING’S NEWest jet, the 787 Dreamliner, took its
first three-hour test flight. It was a
historic moment: the Dreamliner was the
result of an aerodynamic revolution—a
super efficient airplane designed to cut
airline operating costs and the first to
use superlight composite materials.
To ensure that the Dreamliner was
sufficiently lightweight and aerodynamic, it underwent over 15,000 hours of
wind tunnel tests—tests that resulted
in subtle design changes that improved
its performance, making it 20% more fuel
efficient and 20% less pollutant emitting
than existing passenger jets.
The first flight of the Dreamliner
was a spectacular advance from the
1903 maiden voyage of the Wright Flyer,
the first successful powered airplane,
in Kitty Hawk, North Carolina. Yet the
Boeing engineers—and all aeronautic
engineers—owe an enormous debt to
the Wright Flyer’s inventors, Wilbur and
Orville Wright.
What made the Wrights truly visionary
was their invention of the wind tunnel, an
apparatus that let them experiment with
many different designs for wings and
control surfaces. Doing experiments with
a miniature airplane, inside a wind tunnel the size of a shipping crate, gave the
Wright brothers the knowledge that would
make heavier-than-air flight possible.
Neither a miniature airplane inside a
packing crate nor a miniature model of the
Dreamliner inside Boeing’s state-of-theart Transonic Wind Tunnel is the same
thing as an actual aircraft in flight. But it
is a very useful model of a flying plane—a
simplified representation of the real thing
that can be used to answer crucial ques-
tions, such as how much lift a given wing
shape will generate at a given airspeed.
Needless to say, testing an airplane
design in a wind tunnel is cheaper and
safer than building a full-scale version
and hoping it will fly. More generally,
models play a crucial role in almost all scientific research—economics very much
included.
In fact, you could say that economic
theory consists mainly of a collection of
models, a series of simplified representations of economic reality that allow us to
understand a variety of economic issues.
In this chapter, we’ll look at two
economic models that are crucially
important in their own right and also
illustrate why such models are so
useful. We’ll conclude with a look at
how economists actually use models in
their work.
25
PA R T 1
W H AT I S E C O N O M I C S ?
A model is a simplified
representation of a real situation
that is used to better understand
real-life situations.
Models in Economics: Some
Important Examples
A model is any simplified representation of reality that is used to better understand real-life situations. But how do we create a simplified representation of an
economic situation?
One possibility—an economist’s equivalent of a wind tunnel—is to find or
create a real but simplified economy. For example, economists interested in the
economic role of money have studied the system of exchange that developed in
World War II prison camps, in which cigarettes became a universally accepted
form of payment even among prisoners who didn’t smoke.
Another possibility is to simulate the workings of the economy on a computer.
For example, when changes in tax law are proposed, government officials use tax
models—large mathematical computer programs—to assess how the proposed
changes would affect different types of people.
Models are important because their simplicity allows economists to focus on
the effects of only one change at a time. That is, they allow us to hold everything
else constant and study how one change affects the overall economic outcome.
The Model That Ate the Economy
Thinkstock
A model is just a model, right? So how
much damage can it do? Economists
probably would have answered that
question quite differently before the
financial meltdown of 2008–2009 than
after it. The financial crisis continues to
reverberate today—a testament to why
economic models are so important. For
an economic model—a bad economic
model, it turns out—played a significant
role in the origins of the crisis.
“The model that ate the economy”
originated in finance theory, the branch
of economics that seeks to understand
what assets like stocks and bonds are
A model that underestimated the risks of
investing in MBSs had dire consequences
for financial firms on Wall Street and for the
global economy.
worth. Financial theorists often get
hired (at very high salaries, mind you) to
devise complex mathematical models to
help investment companies decide what
assets to buy and sell and at what price.
The trouble began with an asset
known as an MBS, which is short for
mortgage-backed security. The owner
of an MBS is entitled to a stream of
earnings based on the payments made
by thousands of people on their home
loans. But an MBS carries with it a
potential problem: those homeowners
can stop paying their mortgages, inflicting losses on the owner of the MBS. So
investors wanted to know how risky an
MBS was—that is, how likely it was to
lose money.
In 2000, a Wall Street financial theorist announced that he had solved the
problem by adopting a huge mathematical simplification. With it, he devised
a simple model for estimating the risk
of an MBS. Financial firms loved the
model because it opened up a huge
and extraordinarily profitable market for
them in the selling of MBSs to investors.
Using the model, financial firms were
able to package and sell billions of dollars in MBSs, generating billions in profits for themselves.
Or investors thought they had calculated the risk of losing money on
an MBS. Some financial experts—
particularly Darrell Duffie, a Stanford
RLD VIE
O
W
FOR INQUIRING MINDS
W
26
University finance professor—warned
from the sidelines that the estimates
of risk calculated by this simple model
were just plain wrong. He, and other
critics, said that in the search for
simplicity, the model seriously underestimated the risk of losing money on
an MBS.
The warnings fell on deaf ears—no
doubt because financial firms were making so much money. Billions of dollars
worth of MBSs were sold to investors in
the United States and abroad. In 2008–
2009, the problems critics warned about
exploded in catastrophic fashion.
Over the previous decade, American
home prices had risen too high, and
mortgages had been extended to many
who were unable to pay. As home prices
fell to earth, millions of homeowners
didn’t pay their mortgages. With losses
mounting for MBS investors, it became
all too clear that the model had indeed
underestimated the risks.
When investors and financial institutions around the world realized the
extent of their losses, the worldwide
economy ground to an abrupt halt.
People lost their homes, companies
went bankrupt, and unemployment
surged. The recovery over the past six
years has been achingly slow, and it
wasn’t until 2014 that the number of
employed Americans returned to prerecession levels.
•
CHAPTER 2
ECONOMIC MODELS: TR ADE-OFFS AND TR ADE
So an important assumption when building economic models is the other
things equal assumption, which means that all other relevant factors remain
unchanged.
But you can’t always find or create a small-scale version of the whole economy,
and a computer program is only as good as the data it uses. (Programmers have
a saying: “garbage in, garbage out.”) For many purposes, the most effective form
of economic modeling is the construction of “thought experiments”: simplified,
hypothetical versions of real-life situations.
In Chapter 1 we illustrated the concept of equilibrium with the example of
how customers at a supermarket would rearrange themselves when a new cash
register opens. Though we didn’t say it, this was an example of a simple model—
an imaginary supermarket, in which many details were ignored. (What were
customers buying? Never mind.) This simple model can be used to answer a “what
if” question: what if another cash register were opened?
As the cash register story showed, it is often possible to describe and analyze
a useful economic model in plain English. However, because much of economics
involves changes in quantities—in the price of a product, the number of units
produced, or the number of workers employed in its production—economists
often find that using some mathematics helps clarify an issue. In particular, a
numerical example, a simple equation, or—especially—a graph can be key to
understanding an economic concept.
Whatever form it takes, a good economic model can be a tremendous
aid to understanding. The best way to grasp this point is to consider some simple
but important economic models and what they tell us.
• First, we will look at the production possibility frontier, a model that helps
economists think about the trade-offs every economy faces.
• We then turn to comparative advantage, a model that clarifies the principle
of gains from trade—trade both between individuals and between countries.
• We will also examine the circular-flow diagram, a schematic representation
that helps us understand how flows of money, goods, and services are channeled through the economy.
In discussing these models, we make considerable use of graphs to represent
mathematical relationships. Graphs play an important role throughout this book.
If you are already familiar with how graphs are used, you can skip the appendix to this chapter, which provides a brief introduction to the use of graphs in
economics. If not, this would be a good time to turn to it.
Trade-offs: The Production Possibility Frontier
The first principle of economics introduced in Chapter 1 is that resources are
scarce and that, as a result, any economy—whether it’s an isolated group of
a few dozen hunter-gatherers or the 6 billion people making up the twentyfirst-century global economy—faces trade-offs. No matter how lightweight the
Boeing Dreamliner is, no matter how efficient Boeing’s assembly line, producing Dreamliners means using resources that therefore can’t be used to produce
something else.
To think about the trade-offs that face any economy, economists often use
the model known as the production possibility frontier. The idea behind this
model is to improve our understanding of trade-offs by considering a simplified
economy that produces only two goods. This simplification enables us to show
the trade-off graphically.
Suppose, for a moment, that the United States was a one-company economy, with
Boeing its sole employer and aircraft its only product. But there would still be a choice
of what kinds of aircraft to produce—say, Dreamliners versus small commuter jets.
27
The other things equal
assumption means that all other
relevant factors remain unchanged.
The production possibility
frontier illustrates the trade-offs
facing an economy that produces
only two goods. It shows the
maximum quantity of one good
that can be produced for any given
quantity produced of the other.
28
PA R T 1
W H AT I S E C O N O M I C S ?
Figure 2-1 shows a hypothetical production possibility frontier representing the tradeoff this one-company economy would face. The frontier—the line in the diagram—
shows the maximum quantity of small jets that Boeing can produce per year given
the quantity of Dreamliners it produces per year, and vice versa. That is, it answers
questions of the form, “What is the maximum quantity of small jets that Boeing can
produce in a year if it also produces 9 (or 15, or 30) Dreamliners that year?”
There is a crucial distinction between points inside or on the production possibility frontier (the shaded area) and outside the frontier. If a production point lies
inside or on the frontier—like point C, at which Boeing produces 20 small jets and
9 Dreamliners in a year—it is feasible. After all, the frontier tells us that if Boeing
produces 20 small jets, it could also produce a maximum of 15 Dreamliners that
year, so it could certainly make 9 Dreamliners.
However, a production point that lies outside the frontier—such as the
hypothetical production point D, where Boeing produces 40 small jets and 30
Dreamliners—isn’t feasible. Boeing can produce 40 small jets and no Dreamliners,
or it can produce 30 Dreamliners and no small jets, but it can’t do both.
In Figure 2-1 the production possibility frontier intersects the horizontal axis
at 40 small jets. This means that if Boeing dedicated all its production capacity to
making small jets, it could produce 40 small jets per year but could produce no
Dreamliners. The production possibility frontier intersects the vertical axis at 30
Dreamliners. This means that if B oeing dedicated all its production capacity to
making Dreamliners, it could produce 30 Dreamliners per year but no small jets.
The figure also shows less extreme trade-offs. For example, if Boeing’s
managers decide to make 20 small jets this year, they can produce at most 15
Dreamliners; this production choice is illustrated by point A. And if Boeing’s
managers decide to produce 28 small jets, they can make at most 9 Dreamliners,
as shown by point B.
Thinking in terms of a production possibility frontier simplifies the complexities of reality. The real-world U.S. economy produces millions of different
goods. Even Boeing can produce more than two different types of planes. Yet it’s
important to realize that even in its simplicity, this stripped-down model gives us
important insights about the real world.
By simplifying reality, the production possibility frontier helps us understand
some aspects of the real economy better than we could without the model: efficiency, opportunity cost, and economic growth.
FIGURE 2-1
The Production Possibility Frontier
The production possibility frontier
illustrates the trade-offs Boeing faces in
producing Dreamliners and small jets. It
shows the maximum quantity of one good
that can be produced given the quantity
of the other good produced. Here,
the maximum quantity of Dreamliners
manufactured per year depends on the
quantity of small jets manufactured that
year, and vice versa. Boeing’s feasible
production is shown by the area inside
or on the curve. Production at point C is
feasible but not efficient. Points A and B
are feasible and efficient in production,
but point D is not feasible.
Quantity of
Dreamliners
D
30
Feasible and
efficient in
production
A
15
9
Not
feasible
Feasible but
not efficient
B
C
Production
possibility
frontier
PPF
0
20
28
40
Quantity of small jets
ECONOMIC MODELS: TR ADE-OFFS AND TR ADE
29
Efficiency First of all, the production possibility frontier is a good way to illustrate the general economic concept of efficiency. Recall from Chapter 1 that an
economy is efficient if there are no missed opportunities—there is no way to
make some people better off without making other people worse off.
One key element of efficiency is that there are no missed opportunities
in production—there is no way to produce more of one good without producing
less of other goods. As long as Boeing operates on its production possibility frontier, its production is efficient. At point A, 15 Dreamliners are the maximum quantity feasible given that Boeing has also committed to producing 20 small jets; at
point B, 9 Dreamliners are the maximum number that can be made given the
choice to produce 28 small jets; and so on.
But suppose for some reason that Boeing was operating at point C, making 20
small jets and 9 Dreamliners. In this case, it would not be operating efficiently and
would therefore be inefficient: it could be producing more of both planes.
Although we have used an example of the production choices of a one-firm, twogood economy to illustrate efficiency and inefficiency, these concepts also carry
over to the real economy, which contains many firms and produces many goods. If
the economy as a whole could not produce more of any one good without producing
less of something else—that is, if it is on its production possibility frontier—then
we say that the economy is efficient in production.
If, however, the economy could produce more
of some things without producing less of others—
which typically means that it could produce more
of everything—then it is inefficient in production.
For example, an economy in which large numbers
of workers are involuntarily unemployed is clearly
inefficient in production. And that’s a bad thing,
because the economy could be producing more
useful goods and services.
Although the production possibility frontier
helps clarify what it means for an economy to be
efficient in production, it’s important to understand that efficiency in production is only part
of what’s required for the economy as a whole
Our imaginary one-company economy is efficient if it (1) produces as
to be efficient. Efficiency also requires that the
many small jets as it can given the production of Dreamliners, and (2) if it
economy allocate its resources so that consumers
produces the mix of small and large planes that people want to consume.
are as well off as possible. If an economy does this,
we say that it is efficient in allocation.
To see why efficiency in allocation is as important as efficiency in production,
notice that points A and B in Figure 2-1 both represent situations in which the
economy is efficient in production, because in each case it can’t produce more of one
good without producing less of the other. But these two situations may not be equally
desirable from society’s point of view. Suppose that society prefers to have more small
jets and fewer Dreamliners than at point A; say, it prefers to have 28 small jets and
9 Dreamliners, corresponding to point B. In this case, point A is inefficient in allocation from the point of view of the economy as a whole because it would rather have
Boeing produce at point B rather than at point A.
This example shows that efficiency for the economy as a whole requires both efficiency in production and efficiency in allocation: to be efficient, an economy must produce as much of each good as it can given the production of other goods, and it must
also produce the mix of goods that people want to consume. And it must also deliver
those goods to the right people: an economy that gives small jets to international airlines
and Dreamliners to commuter airlines serving small rural airports is inefficient, too.
In the real world, command economies, such as the former Soviet Union, are
notorious for inefficiency in allocation. For example, it was common for consumers to find stores well stocked with items few people wanted but lacking such
basics as soap and toilet paper.
istockphoto
CHAPTER 2
30
PA R T 1
W H AT I S E C O N O M I C S ?
Opportunity Cost The production possibility frontier is also useful as a
reminder of the fundamental point that the true cost of any good isn’t the money
it costs to buy, but what must be given up in order to get that good—the opportunity cost. If, for example, Boeing decides to change its production from point
A to point B, it will produce 8 more small jets but 6 fewer Dreamliners. So the
opportunity cost of 8 small jets is 6 Dreamliners—the 6 Dreamliners that must
be forgone in order to produce 8 more small jets. This means that each small jet
has an opportunity cost of 6/ 8 = 3/ 4 of a Dreamliner.
Is the opportunity cost of an extra small jet in terms of Dreamliners always the
same, no matter how many small jets and Dreamliners are currently produced?
In the example illustrated by Figure 2-1, the answer is yes. If Boeing increases its
production of small jets from 28 to 40, the number of Dreamliners it produces falls
from 9 to zero. So Boeing’s opportunity cost per additional small jet is 9/12 = 3/4 of a
Dreamliner, the same as it was when Boeing went from 20 small jets produced to 28.
However, the fact that in this example the opportunity cost of a small jet in
terms of a Dreamliner is always the same is a result of an assumption we’ve made,
an assumption that’s reflected in how Figure 2-1 is drawn. Specifically, whenever
we assume that the opportunity cost of an additional unit of a good doesn’t change
regardless of the output mix, the production possibility frontier is a straight line.
Moreover, as you might have already guessed, the slope of a straight-line
production possibility frontier is equal to the opportunity cost—specifically, the
opportunity cost for the good measured on the horizontal axis in terms of the
good measured on the vertical axis. In Figure 2-1, the production possibility frontier has a constant slope of −3/4, implying that Boeing faces a constant opportunity
cost for 1 small jet equal to 3/4 of a Dreamliner. (A review of how to calculate the
slope of a straight line is found in this chapter’s appendix.) This is the simplest
case, but the production possibility frontier model can also be used to examine
situations in which opportunity costs change as the mix of output changes.
Figure 2-2 illustrates a different assumption, a case in which Boeing faces
increasing opportunity cost. Here, the more small jets it produces, the more
costly it is to produce yet another small jet in terms of forgone production of a
Dreamliner. And the same holds true in reverse: the more Dreamliners Boeing
produces, the more costly it is to produce yet another Dreamliner in terms of forgone production of small jets. For example, to go from producing zero small jets
to producing 20, Boeing has to forgo producing 5 Dreamliners. That is, the opportunity cost of those 20 small jets is 5 Dreamliners. But to increase its production
FIGURE 2-2
Increasing Opportunity Cost
The bowed-out shape of the
production possibility frontier reflects
increasing opportunity cost. In
this example, to produce the first
20 small jets, Boeing must forgo
producing 5 Dreamliners. But to
produce an additional 20 small jets,
Boeing must forgo manufacturing 25
more Dreamliners.
Quantity of
Dreamliners
35
. . . requires giving
up 5 Dreamliners.
Producing the first
20 small jets . . .
But producing 20
more small jets . . .
30
A
25
20
. . . requires
giving up 25
more Dreamliners.
15
10
5
PPF
0
10
20
30
40
50
Quantity of small jets
CHAPTER 2
ECONOMIC MODELS: TR ADE-OFFS AND TR ADE
of small jets to 40—that is, to produce an additional 20 small jets—it must forgo
producing 25 more Dreamliners, a much higher opportunity cost. As you can see
in Figure 2-2, when opportunity costs are increasing rather than constant, the
production possibility frontier is a bowed-out curve rather than a straight line.
Although it’s often useful to work with the simple assumption that the production possibility frontier is a straight line, economists believe that in reality opportunity costs are typically increasing. When only a small amount of a good is produced,
the opportunity cost of producing that good is relatively low because the economy
needs to use only those resources that are especially well suited for its production.
For example, if an economy grows only a small amount of corn, that corn can
be grown in places where the soil and climate are perfect for corn-growing but
less suitable for growing anything else, like wheat. So growing that corn involves
giving up only a small amount of potential wheat output. Once the economy
grows a lot of corn, however, land that is well suited for wheat but isn’t so great
for corn must be used to produce corn anyway. As a result, the additional corn
production involves sacrificing considerably more wheat production. In other
words, as more of a good is produced, its opportunity cost typically rises because
well-suited inputs are used up and less adaptable inputs must be used instead.
Economic Growth Finally, the production possibility frontier helps us understand what it means to talk about economic growth. In the Introduction, we
defined the concept of economic growth as the growing ability of the economy to
produce goods and services. As we saw, economic growth is one of the fundamental
features of the real economy. But are we really justified in saying that the economy
has grown over time? After all, although the U.S. economy produces more of many
things than it did a century ago, it produces less of other things—for example,
horse-drawn carriages. Production of many goods, in other words, is actually
down. So how can we say for sure that the economy as a whole has grown?
The answer is illustrated in Figure 2-3, where we have drawn two hypothetical
production possibility frontiers for the economy. In them we have assumed once
again that everyone in the economy works for Boeing and, consequently, the economy produces only two goods, Dreamliners and small jets. Notice how the two
curves are nested, with the one labeled “Original PPF” lying completely inside the
one labeled “New PPF.” Now we can see graphically what we mean by economic
growth of the economy: economic growth means an expansion of the economy’s
production possibilities; that is, the economy can produce more of everything.
FIGURE 2-3
Economic Growth
Economic growth results in an
outward shift of the production
possibility frontier because
production possibilities are
expanded. The economy can now
produce more of everything. For
example, if production is initially at
point A (25 Dreamliners and 20 small
jets), economic growth means that
the economy could move to point E
(30 Dreamliners and 25 small jets).
Quantity of
Dreamliners
35
E
30
A
25
20
15
10
5
Original
PPF
0
10
20
25
30
New
PPF
40
50
Quantity of small jets
31
32
PA R T 1
W H AT I S E C O N O M I C S ?
For example, if the economy initially produces at point A (25 Dreamliners and
20 small jets), economic growth means that the economy could move to point E (30
Dreamliners and 25 small jets). E lies outside the original frontier; so in the production possibility frontier model, growth is shown as an outward shift of the frontier.
Technology is the technical means
for producing goods and services.
What can lead the production possibility frontier to shift outward? There are
basically two sources of economic growth. One is an increase in the economy’s
factors of production, the resources used to produce goods and services.
Economists usually use the term factor of production to refer to a resource that
is not used up in production. For example, in traditional airplane manufacture
workers used riveting machines to connect metal sheets when constructing a
plane’s fuselage; the workers and the riveters are factors of production, but the
rivets and the sheet metal are not. Once a fuselage is made, a worker and riveter
can be used to make another fuselage, but the sheet metal and rivets used to make
one fuselage cannot be used to make another.
Broadly speaking, the main factors of production are the resources land,
labor, physical capital, and human capital. Land is a resource supplied by nature;
labor is the economy’s pool of workers; physical capital refers to created resources
such as machines and buildings; and human capital refers to the educational
achievements and skills of the labor force, which enhance its productivity. Of
course, each of these is really a category rather than a single factor: land in North
Dakota is quite different from land in Florida.
To see how adding to an economy’s factors of production leads to economic
growth, suppose that Boeing builds another construction hangar that allows it to
increase the number of planes—small jets or Dreamliners or both—it can produce
in a year. The new construction hangar is a factor of production, a resource Boeing
can use to increase its yearly output. We can’t say how many more planes of each
type Boeing will produce; that’s a management decision that will depend on, among
other things, customer demand. But we can say that Boeing’s production possibility
frontier has shifted outward because it can now produce more small jets without
reducing the number of Dreamliners it makes, or it can make more Dreamliners
without reducing the number of small jets produced.
The other source of economic growth is progress in technology, the technical
means for the production of goods and services. Composite materials had been
used in some parts of aircraft before the Boeing
Dreamliner was developed. But Boeing engineers
realized that there were large additional advantages
to building a whole plane out of composites. The
plane would be lighter, stronger, and have better
aerodynamics than a plane built in the traditional
way. It would therefore have longer range, be able to
carry more people, and use less fuel, in addition to
being able to maintain higher cabin pressure. So in a
real sense Boeing’s innovation—a whole plane built
out of composites—was a way to do more with any
given amount of resources, pushing out the production possibility frontier.
Because improved jet technology has pushed
out the production possibility frontier, it has made
it possible for the economy to produce more of
everything, not just jets and air travel. Over the
past 30 years, the biggest technological advances
have taken place in information technology, not in
construction or food services. Yet Americans have
chosen to buy bigger houses and eat out more than
they used to because the economy’s growth has
The four factors of production: land, labor, physical capital, and human
made it possible to do so.
istockphoto/Thinkstock
istockphoto/Thinkstock
Comstock/Thinkstock
istockphoto/Thinkstock
Factors of production are
resources used to produce goods
and services.
capital.
CHAPTER 2
ECONOMIC MODELS: TR ADE-OFFS AND TR ADE
The production possibility frontier is a very simplified model of an economy.
Yet it teaches us important lessons about real-life economies. It gives us our first
clear sense of what constitutes economic efficiency, it illustrates the concept of
opportunity cost, and it makes clear what economic growth is all about.
Comparative Advantage and Gains from Trade
Among the twelve principles of economics described in Chapter 1 was the
principle of gains from trade—the mutual gains that individuals can achieve by
specializing in doing different things and trading with one another. Our second
illustration of an economic model is a particularly useful model of gains from
trade—trade based on comparative advantage.
One of the most important insights in all of economics is that there are gains
from trade—that it makes sense to produce the things you’re especially good at
producing and to buy from other people the things you aren’t as good at producing. This would be true even if you could produce everything for yourself: even
if a brilliant brain surgeon could repair her own dripping faucet, it’s probably a
better idea for her to call in a professional plumber.
How can we model the gains from trade? Let’s stay with our aircraft example
and once again imagine that the United States is a one-company economy where
everyone works for Boeing, producing airplanes. Let’s now assume, however,
that the United States has the ability to trade with Brazil—another one-company
economy where everyone works for the Brazilian aircraft company Embraer,
which is, in the real world, a successful producer of small commuter jets. (If you
fly from one major U.S. city to another, your plane is likely to be a Boeing, but if
you fly into a small city, the odds are good that your plane will be an Embraer.)
In our example, the only two goods produced are large jets and small jets. Both
countries could produce both kinds of jets. But as we’ll see in a moment, they can
gain by producing different things and trading with each other. For the purposes of
this example, let’s return to the simpler case of straight-line production possibility
frontiers. America’s production possibilities are represented by the production possibility frontier in panel (a) of Figure 2-4, which is similar to the production possibility
FIGURE 2-4
Production Possibilities for Two Countries
(a) U.S. Production Possibilities
Quantity of
large jets
(b) Brazilian Production Possibilities
Quantity of
large jets
30
U.S. consumption
without trade
18
Brazilian consumption
without trade
10
8
U.S.
Brazilian
PPF
PPF
0
16
40
Quantity of small jets
Here, both the United States and Brazil have a constant
opportunity cost of small jets, illustrated by a straight-line
production possibility frontier. For the United States, each
0
6
30
Quantity of small jets
small jet has an opportunity cost of 3⁄4 of a large jet. Brazil has
an opportunity cost of a small jet equal to 1⁄3 of a large jet.
33
34
PA R T 1
TABLE 2-1
One small jet
One large jet
W H AT I S E C O N O M I C S ?
frontier in Figure 2-1. According to this diagram, the United States can produce
40 small jets if it makes no large jets and can manufacture 30 large jets if it produces
no small jets. Recall that this means that the slope of the U.S. production possibility
frontier is −3/4: its opportunity cost of 1 small jet is 3/4 of a large jet.
Panel (b) of Figure 2-4 shows Brazil’s production possibilities. Like the
United States, Brazil’s production possibility frontier is a straight line, implying
a constant opportunity cost of a small jet in terms of large
jets. Brazil’s production possibility frontier has a constant
U.S. and Brazilian Opportunity
slope of – 1/3. Brazil can’t produce as much of anything as
Costs of Small Jets and Large Jets
the United States can: at most it can produce 30 small jets
U.S.
Brazilian
or 10 large jets. But it is relatively better at manufacturing
Opportunity
Opportunity
small jets than the United States; whereas the United States
Cost
Cost
sacrifices 3/4 of a large jet per small jet produced, for Brazil
¾ large jet
> 1/3 large jet
the opportunity cost of a small jet is only 1/3 of a large jet.
4/3 small jets
< 3 small jets
Table 2-1 summarizes the two countries’ opportunity costs of
small jets and large jets.
Now, the United States and Brazil could each choose to
make their own large and small jets, not trading any airplanes and consuming only
what each produced within its own country. (A country “consumes” an airplane
when it is owned by a domestic resident.) Let’s suppose that the two countries
start out this way and make the consumption choices shown in Figure 2-4: in the
absence of trade, the United States produces and consumes 16 small jets and 18
large jets per year, while Brazil produces and consumes 6 small jets and 8 large
jets per year.
But is this the best the two countries can do? No, it isn’t. Given that the two
producers—and therefore the two countries—have different opportunity costs,
the United States and Brazil can strike a deal that makes both of them better off.
Table 2-2 shows how such a deal works: the United States specializes in the production of large jets, manufacturing 30 per year, and sells 10 to Brazil. Meanwhile,
Brazil specializes in the production of small jets, producing 30 per year, and sells
20 to the United States. The result is shown in Figure 2-5. The United States now
consumes more of both small jets and large jets than before: instead of 16 small
jets and 18 large jets, it now consumes 20 small jets and 20 large jets. Brazil also
consumes more, going from 6 small jets and 8 large jets to 10 small jets and 10 large
jets. As Table 2-2 also shows, both the United States and Brazil reap gains from
trade, consuming more of both types of plane than they would have without trade.
TABLE 2-2
How the United States and Brazil Gain from Trade
Without Trade
United
States
Brazil
A country has a comparative
advantage in producing a good
or service if its opportunity cost of
producing the good or service is
lower than other countries’. Likewise,
an individual has a comparative
advantage in producing a good or
service if his or her opportunity cost
of producing the good or service is
lower than for other people.
With Trade
Production
Consumption
Production
Consumption
Gains from
Trade
Large jets
18
18
30
20
+2
Small jets
16
16
0
20
+4
Large jets
8
8
0
10
+2
Small jets
6
6
30
10
+4
Both countries are better off when they each specialize in what they are
good at and trade. It’s a good idea for the United States to specialize in the production of large jets because its opportunity cost of a large jet is smaller than
Brazil’s: 4/3 < 3. Correspondingly, Brazil should specialize in the production of
small jets because its opportunity cost of a small jet is smaller than the United
States: 1/ 3 < 3/4.
What we would say in this case is that the United States has a comparative
advantage in the production of large jets and Brazil has a comparative advantage in the production of small jets. A country has a comparative advantage in
CHAPTER 2
FIGURE 2-5
ECONOMIC MODELS: TR ADE-OFFS AND TR ADE
Comparative Advantage and Gains from Trade
(a) U.S. Production and Consumption
Quantity of
large jets
30
(b) Brazilian Production and Consumption
Quantity of
large jets
U.S. production
with trade
U.S. consumption
without trade
20
18
Brazilian consumption
without trade
U.S. consumption
with trade
Brazilian consumption
with trade
10
8
Brazilian
PPF
U.S.
PPF
0
16 20
40
Quantity of small jets
By specializing and trading, the United States and Brazil can
produce and consume more of both large jets and small jets.
The United States specializes in manufacturing large jets, its
comparative advantage, and Brazil—which has an absolute
0
6 10
Brazilian
production
with trade
30
Quantity of small jets
disadvantage in both goods but a comparative advantage in
small jets—specializes in manufacturing small jets. With trade,
both countries can consume more of both goods than either
could without trade.
producing something if the opportunity cost of that production is lower for that
country than for other countries. The same concept applies to firms and people: a
firm or an individual has a comparative advantage in producing something if its,
his, or her opportunity cost of production is lower than for others.
One point of clarification before we proceed further. You may have wondered
why the United States traded 10 large jets to Brazil in return for 20 small jets. Why
not some other deal, like trading 10 large jets for 12 small jets? The answer to that
question has two parts. First, there may indeed be other trades that the United States
and Brazil might agree to. Second, there are some deals that we can safely rule out—
one like 10 large jets for 10 small jets.
To understand why, reexamine Table 2-1 and consider the United States first. Without trading with Brazil, the U.S. opportunity cost of a small jet is 3/4 of a large jet. So
it’s clear that the United States will not accept any trade that requires it to give up more
than 3/4 of a large jet for a small jet. Trading 10 jets in return for 12 small jets would
require the United States to pay an opportunity cost of 10/12 = 5/6 of a large jet for a small
jet. Because 5/6 > than 3/4, this is a deal that the United States would reject. Similarly,
Brazil won’t accept a trade that gives it less than 1/3 of a large jet for a small jet.
The point to remember is that the United States and Brazil will be willing
to trade only if the “price” of the good each country obtains in the trade is less
than its own opportunity cost of producing the good domestically. Moreover,
this is a general statement that is true whenever two parties—countries, firms,
or individuals—trade voluntarily.
While our story clearly simplifies reality, it teaches us some very important
lessons that apply to the real economy, too.
First, the model provides a clear illustration of the gains from trade: through
specialization and trade, both countries produce more and consume more than
if they were self-sufficient.
Second, the model demonstrates a very important point that is often overlooked
in real-world arguments: each country has a comparative advantage in producing
something. This applies to firms and people as well: everyone has a comparative
advantage in something, and everyone has a comparative disadvantage in something.
35
36
PA R T 1
W H AT I S E C O N O M I C S ?
A country has an absolute
advantage in producing a good or
service if the country can produce
more output per worker than other
countries. Likewise, an individual
has an absolute advantage in
producing a good or service if he
or she is better at producing it than
other people. Having an absolute
advantage is not the same thing as
having a comparative advantage.
Crucially, in our example it doesn’t matter if, as is probably the case in real
life, U.S. workers are just as good as or even better than Brazilian workers at
producing small jets. Suppose that the United States is actually better than
Brazil at all kinds of aircraft production. In that case, we would say that the
United States has an absolute advantage in both large-jet and small-jet production: in an hour, an American worker can produce more of either a large
jet or a small jet than a Brazilian worker. You might be tempted to think that
in that case the United States has nothing to gain from trading with the less
productive Brazil.
But we’ve just seen that the United States can indeed benefit from trading with
Brazil because comparative, not absolute, advantage is the basis for mutual gain. It
doesn’t matter whether it takes Brazil more resources than the United States to
make a small jet; what matters for trade is that for Brazil the opportunity cost of
a small jet is lower than the U.S. opportunity cost. So Brazil, despite its absolute
disadvantage, even in small jets, has a comparative advantage in the manufacture of small jets. Meanwhile the United States, which can use its resources most
productively by manufacturing large jets, has a comparative disadvantage in
manufacturing small jets.
Comparative Advantage and International
Trade, in Reality
Look at the label on a manufactured good sold in the United States, and there’s a
good chance you will find that it was produced in some other country—in China,
or Japan, or even in Canada, eh? On the other side, many U.S. industries sell a
large fraction of their output overseas. (This is particularly true of agriculture,
high technology, and entertainment.)
Should all this international exchange of goods and services be celebrated, or
is it cause for concern? Politicians and the public often question the desirability of
international trade, arguing that the nation should produce goods for itself rather
than buying them from foreigners. Industries around the world demand protection from foreign competition: Japanese farmers want to keep out American rice,
American steelworkers want to keep out European steel. And these demands are
often supported by public opinion.
Economists, however, have a very positive view of international trade. Why?
Because they view it in terms of comparative advantage. As we learned from
our example of U.S. large jets and Brazilian small jets, international trade benefits both countries. Each country can consume more than if it didn’t trade and
remained self-sufficient. Moreover, these mutual gains don’t depend on each
country being better than other countries at producing one kind of good. Even if
one country has, say, higher output per worker in both industries—that is, even
P I T FA L L S
MISUNDERSTANDING COMPARATIVE
ADVANTAGE
Students do it, pundits do it, and politicians
do it all the time: they confuse comparative
advantage with absolute advantage. For
example, back in the 1980s, when the U.S.
economy seemed to be lagging behind that
of Japan, one often heard commentators
warn that if we didn’t improve our productivity, we would soon have no comparative
advantage in anything.
What those commentators meant was
that we would have no absolute advantage
in anything—that there might come a time
when the Japanese were better at everything than we were. (It didn’t turn out that
way, but that’s another story.) And they
had the idea that in that case we would no
longer be able to benefit from trade with
Japan.
But just as Brazil, in our example, was
able to benefit from trade with the United
States (and vice versa) despite the fact that
the United States was better at manufacturing both large and small jets, in real life
nations can still gain from trade even if they
are less productive in all industries than the
countries they trade with.
CHAPTER 2
GLOBAL
COMPARISION
37
ECONOMIC MODELS: TR ADE-OFFS AND TR ADE
Pajama Republics
I
n April 2013, a terrible industrial disaster made world
headlines: in Bangladesh, a building housing five clothing
factories collapsed, killing more than a thousand garment
workers trapped inside. Attention soon focused on the substandard working conditions in those factories, as well as the
many violations of building codes and safety procedures—
including those required by Bangladeshi law—that set the
stage for the tragedy.
While the story provoked a justified outcry, it also highlighted the remarkable rise of Bangladesh’s clothing industry,
which has become a major player in world markets—second
only to China in total exports—and a desperately needed
source of income and employment in a very poor country.
It’s not that Bangladesh has especially high productivity in clothing manufacturing. In fact, recent estimates by
the consulting firm McKinsey and Company suggest that
it’s about a quarter less productive than China. Rather, it
has even lower productivity in other industries, giving it a
comparative advantage in clothing manufacturing. This is
typical in poor countries, which often rely heavily on clothing
exports during the early phases of their economic development. An official from one such country once joked, “We are
not a banana republic—we are a pajama republic.”
The figure plots the per capita income of several such
“pajama republics” (the total income of the country divided
by the size of the population) against the share of total
exports accounted for by clothing; per capita income is
measured as a percentage of the U.S. level in order to give
you a sense of just how poor these countries are. As you can
see, they are very poor indeed—and the poorer they are, the
more they depend on clothing exports.
It’s worth pointing out, by the way, that relying on clothing exports is by no means necessarily a bad thing, despite
tragedies like the Bangladesh factory disaster. Indeed,
Bangladesh, although still desperately poor, is more than
twice as rich as it was two decades ago, when it began its
dramatic rise as a clothing exporter. (Also see the upcoming
Economics in Action on Bangladesh.)
Clothing exports
80%
(percent of total
exports)
60
Bangladesh
Cambodia
Sri Lanka
40
Honduras
20
0
Vietnam
China
Mexico
10%
20
30
40
Income per capita
(percent of U.S. GDP)
Source: WTO.
if one country has an absolute advantage in both industries—there are still gains
from trade. The upcoming Global Comparison, which explains the pattern of
clothing production in the global economy, illustrates just this point.
Transactions: The Circular-Flow Diagram
The model economies that we’ve studied so far—each containing only one firm—are
a huge simplification. We’ve also greatly simplified trade between the United States
and Brazil, assuming that they engage only in the simplest of economic transactions, barter, in which one party directly trades a good or service for another good
or service without using money. In a modern economy, simple barter is rare: usually
people trade goods or services for money—pieces of colored paper with no inherent
value—and then trade those pieces of colored paper for the goods or services they
want. That is, they sell goods or services and buy other goods or services.
And they both sell and buy a lot of different things. The U.S. economy is a
vastly complex entity, with more than a hundred million workers employed by
millions of companies, producing millions of different goods and services. Yet
you can learn some very important things about the economy by considering the
simple graphic shown in Figure 2-6, the circular-flow diagram. This diagram
represents the transactions that take place in an economy by two kinds of flows
around a circle: flows of physical things such as goods, services, labor, or raw
materials in one direction, and flows of money that pay for these physical things
in the opposite direction. In this case the physical flows are shown in yellow, the
money flows in green.
Trade takes the form of barter when
people directly exchange goods or
services that they have for goods or
services that they want.
The circular-flow diagram
represents the transactions in an
economy by flows around a circle.
38
PA R T 1
FIGURE 2-6
W H AT I S E C O N O M I C S ?
The Circular-Flow Diagram
This diagram represents the flows
of money and of goods and services
in the economy. In the markets for
goods and services, households
purchase goods and services from
firms, generating a flow of money to
the firms and a flow of goods and
services to the households. The
money flows back to households as
firms purchase factors of production
from the households in factor
markets.
Money
Money
Households
Goods
and
services
Factors
Markets for
goods and
services
Factor markets
Goods
and
services
Factors
Money
Money
Firms
A household is a person or a group
of people that share their income.
A firm is an organization that
produces goods and services for sale.
Firms sell goods and services that
they produce to households in
markets for goods and services.
Firms buy the resources they need
to produce goods and services in
factor markets.
An economy’s income distribution
is the way in which total income is
divided among the owners of the
various factors of production.
The simplest circular-flow diagram illustrates an economy that contains only
two kinds of inhabitants: households and firms. A household consists of either
an individual or a group of people (usually, but not necessarily, a family) that
share their income. A firm is an organization that produces goods and services
for sale—and that employs members of households.
As you can see in Figure 2-6, there are two kinds of markets in this simple economy.
On one side (here the left side) there are markets for goods and services in which
households buy the goods and services they want from firms. This produces a flow of
goods and services to households and a return flow of money to firms.
On the right side, there are factor markets in which firms buy the resources
they need to produce goods and services. Recall from earlier that the main factors
of production are land, labor, physical capital, and human capital.
The factor market most of us know best is the labor market, in which workers
sell their services. In addition, we can think of households as owning and selling
the other factors of production to firms. For example, when a firm buys physical
capital in the form of machines, the payment ultimately goes to the households that
own the machine-making firm. In this case, the transactions are occurring in the
capital market, the market in which capital is bought and sold. As we’ll examine in
detail later, factor markets ultimately determine an economy’s income distribution, how the total income created in an economy is allocated between less skilled
workers, highly skilled workers, and the owners of capital and land.
The circular-flow diagram ignores a number of real-world complications in
the interests of simplicity. A few examples:
• In the real world, the distinction between firms and households isn’t always
that clear-cut. Consider a small, family-run business—a farm, a shop, a small
hotel. Is this a firm or a household? A more complete picture would include a
separate box for family businesses.
• Many of the sales firms make are not to households but to other firms; for
example, steel companies sell mainly to other companies such as auto manufacturers, not to households. A more complete picture would include these
flows of goods, services, and money within the business sector.
CHAPTER 2
ECONOMIC MODELS: TR ADE-OFFS AND TR ADE
39
• The figure doesn’t show the government, which in the real world diverts quite
a lot of money out of the circular flow in the form of taxes but also injects a
lot of money back into the flow in the form of spending.
in Action
RLD VIE
O
W
s
ECONOMICS
W
Figure 2-6, in other words, is by no means a complete picture either of all the
types of inhabitants of the real economy or of all the flows of money and physical
items that take place among these inhabitants.
Despite its simplicity, the circular-flow diagram is a very useful aid to thinking about the economy.
Rich Nation, Poor Nation
Check Your Understanding
2-1
1. True or false? Explain your answer.
a. A n increase in the amount of resources available to Boeing for use in producing
Dreamliners and small jets does not change its production possibility frontier.
b. A technological change that allows Boeing to build more small jets for any amount
of Dreamliners built results in a change in its production possibility frontier.
c. The production possibility frontier is useful because it illustrates how much of
one good an economy must give up to get more of another good regardless of
whether resources are being used efficiently.
2. In Italy, an automobile can be produced by 8 workers in one day and a washing
machine by 3 workers in one day. In the United States, an automobile can be produced
by 6 workers in one day and a washing machine by 2 workers in one day.
is often confused with absolute
advantage.
• In the simplest economies people
barter rather than transact with
money. The circular-flow diagram
illustrates transactions within the
economy as flows of goods and
services, factors of production,
and money between households
and firms. These transactions occur
in markets for goods and services
and factor markets. Ultimately,
factor markets determine the
economy’s income distribution.
Robert Nickelsberg/Getty Images
T
ry taking off your clothes—at a suitable time and in a suitable
place, of course—and taking a look at the labels inside that
say where they were made. It’s a very good bet that much, if
not most, of your clothing was manufactured overseas, in a country
that is much poorer than the United States—say, in El Salvador, Sri
Lanka, or Bangladesh.
Why are these countries so much poorer than we are? The immediate reason is that their economies are much less productive—firms
in these countries are just not able to produce as much from a given
quantity of resources as comparable firms in the United States or
other wealthy countries. Why countries differ so much in productivity
is a deep question—indeed, one of the main questions that preoccupy
economists. But in any case, the difference in productivity is a fact.
Although less productive than American workers,
But if the economies of these countries are so much less productive
Bangladeshi workers have a comparative advanthan ours, how is it that they make so much of our clothing? Why don’t
tage in clothing production.
we do it for ourselves?
The answer is “comparative advantage.” Just about every industry in
Quick Review
Bangladesh is much less productive than the corresponding industry in the
United States. But the productivity difference between rich and poor countries
• Most economic models
are “thought experiments” or
varies across goods; it is very large in the production of sophisticated goods like
simplified representations of
aircraft but not that large in the production of simpler goods like clothing. So
reality that rely on the other
Bangladesh’s position with regard to clothing production is like Embraer’s posithings equal assumption.
tion with respect to producing small jets: it’s not as good at it as Boeing, but it’s
• The production possibility
the thing Embraer does comparatively well.
frontier model illustrates the
Bangladesh, though it is at an absolute disadvantage compared with the
concepts of efficiency, opportunity
United States in almost everything, has a comparative advantage in clothing
cost, and economic growth.
production. This means that both the United States and Bangladesh are able
• Every person and every country
to consume more because they specialize in producing different things, with
has a comparative advantage
Bangladesh supplying our clothing and the United States supplying Bangladesh
in something, giving rise to gains
with more sophisticated goods.
from trade. Comparative advantage
40
PA R T 1
W H AT I S E C O N O M I C S ?
a. Which country has an absolute advantage in the production of automobiles? In
washing machines?
b. Which country has a comparative advantage in the production of washing
machines? In automobiles?
c. What pattern of specialization results in the greatest gains from trade between
the two countries?
3.Using the numbers from Table 2-1, explain why the United States and Brazil are
willing to engage in a trade of 10 large jets for 15 small jets.
4. Use the circular-flow diagram to explain how an increase in the amount of money
spent by households results in an increase in the number of jobs in the economy.
Describe in words what the circular-flow diagram predicts.
Solutions appear at back of book.
Using Models
Economics, we have now learned, is mainly a matter of creating models that
draw on a set of basic principles but add some more specific assumptions that
allow the modeler to apply those principles to a particular situation. But what do
economists actually do with their models?
Positive versus Normative Economics
Imagine that you are an economic adviser to the governor of your state. What
kinds of questions might the governor ask you to answer?
Well, here are three possible questions:
1. How much revenue will the tolls on the state turnpike yield next year?
2. How much would that revenue increase if the toll were raised from $1 to $1.50?
3. Should the toll be raised, bearing in mind that a toll increase will reduce traffic and air pollution near the road but will impose some financial hardship on
frequent commuters?
Positive economics is the branch
of economic analysis that describes
the way the economy actually works.
Normative economics makes
prescriptions about the way the
economy should work.
There is a big difference between the first two questions and the third one.
The first two are questions about facts. Your forecast of next year’s toll collection will be proved right or wrong when the numbers actually come in. Your
estimate of the impact of a change in the toll is a little harder to check—revenue
depends on other factors besides the toll, and it may be hard to disentangle
the causes of any change in revenue. Still, in principle there is only one right
answer.
But the question of whether tolls should be raised may not have a “right”
answer—two people who agree on the effects of a higher toll could still disagree
about whether raising the toll is a good idea. For example, someone who lives
near the turnpike but doesn’t commute on it will care a lot about noise and air
pollution but not so much about commuting costs. A regular commuter who
doesn’t live near the turnpike will have the opposite priorities.
This example highlights a key distinction between two roles of economic
analysis. Analysis that tries to answer questions about the way the world works,
which have definite right and wrong answers, is known as positive economics.
In contrast, analysis that involves saying how the world should work is known
as normative economics. To put it another way, positive economics is about
description; normative economics is about prescription.
Positive economics occupies most of the time and effort of the economics
profession. And models play a crucial role in almost all positive economics. As we
mentioned earlier, the U.S. government uses a computer model to assess proposed
changes in national tax policy, and many state governments have similar models
to assess the effects of their own tax policy.
CHAPTER 2
ECONOMIC MODELS: TR ADE-OFFS AND TR ADE
It’s worth noting that there is a subtle but important difference between the
first and second questions we imagined the governor asking. Question 1 asked
for a simple prediction about next year’s revenue—a forecast. Question 2 was a
“what if” question, asking how revenue would change if the tax law were changed.
Economists are often called upon to answer both types of questions, but models
are especially useful for answering “what if” questions.
The answers to such questions often serve as a guide to policy, but they are
still predictions, not prescriptions. That is, they tell you what will happen if a
policy were changed; they don’t tell you whether or not that result is good.
Suppose your economic model tells you that the governor’s proposed increase
in highway tolls will raise property values in communities near the road but
will hurt people who must use the turnpike to get to work. Does that make this
proposed toll increase a good idea or a bad one? It depends on whom you ask.
As we’ve just seen, someone who is very concerned with the communities near
the road will support the increase, but someone who is very concerned with the
welfare of drivers will feel differently. That’s a value judgment—it’s not a question
of economic analysis.
Still, economists often do engage in normative economics and give policy
advice. How can they do this when there may be no “right” answer?
One answer is that economists are also citizens, and we all have our opinions.
But economic analysis can often be used to show that some policies are clearly
better than others, regardless of anyone’s opinions.
Suppose that policies A and B achieve the same goal, but policy A makes everyone better off than policy B—or at least makes some people better off without making other people worse off. Then A is clearly more efficient than B. That’s not a value
judgment: we’re talking about how best to achieve a goal, not about the goal itself.
For example, two different policies have been used to help low-income families obtain housing: rent control, which limits the rents landlords are allowed to
charge, and rent subsidies, which provide families with additional money to pay
rent. Almost all economists agree that subsidies are the more efficient policy.
And so the great majority of economists, whatever their personal politics, favor
subsidies over rent control.
When policies can be clearly ranked in this way, then economists generally
agree. But it is no secret that economists sometimes disagree.
41
A forecast is a simple prediction of
the future.
Economists have a reputation for arguing with each other. Where does this reputation come from, and is it justified?
One important answer is that media coverage tends to exaggerate the real differences in views among economists. If nearly all economists agree on an issue—for
example, the proposition that rent controls lead to housing shortages—reporters
and editors are likely to conclude that it’s not a story worth covering,
leaving the professional consensus unreported. But an issue on which
prominent economists take opposing sides—for example, whether cutting taxes right now would help the economy—makes a news story
worth reporting. So you hear much more about the areas of disagreement within economics than you do about the large areas of agreement.
It is also worth remembering that economics is, unavoidably, often
tied up in politics. On a number of issues powerful interest groups
know what opinions they want to hear; they therefore have an incentive to find and promote economists who profess those opinions, giving these economists a prominence and visibility out of proportion to
their support among their colleagues.
While the appearance of disagreement among economists exceeds
the reality, it remains true that economists often do disagree about
important things. For example, some well respected economists argue
Toles ©2001 The Buffalo News. Reprinted with permission of
Universal Press Syndicate. All rights reserved.
When and Why Economists Disagree
W H AT I S E C O N O M I C S ?
have it, even on supposedly controversial
topics. For example, 80% of the panel
agreed that the American Recovery and
Reconstruction Act of 2009—the socalled Obama stimulus—led to higher
growth and employment, although there
was more division about whether the
plan was worth its cost.
Roughly the same percentage—82%—
disagreed with the proposition that rent
control increases the supply of quality,
affordable housing.
In the first case, by the way, the panel
of economists overwhelmingly agreed
with a position widely considered liberal
in American politics, while in the second
case they agreed with a position widely
considered politically conservative.
Were there areas of substantial disagreement among the economists? Yes,
but they tended to involve untested
economic policies. There was, for example, an almost even split over whether
new Federal Reserve tactics aimed at
boosting the economy would work.
Perhaps even more surprising than
the relative lack of disagreement among
economists was the relative absence of
Shoey Sindel Photography
“If all the economists in the world were
laid end to end, they still couldn’t reach
a conclusion.” So goes one popular
economist joke. But do economists
really disagree that much?
Not according to an ongoing survey
being conducted by the Booth School
of Business at the University of Chicago.
The Booth School assembled a panel
of 41 economists, all with exemplary
professional reputations, representing
a mix of regions, schools, and political
affiliations, and officially known as the
Economic Experts Panel of Chicago
Booth’s Initiative on Global Markets. Four
of these economists are pictured here
(clockwise from top left): Amy Finkelstein
of MIT, Hilary Hoynes of UC Berkeley,
Emmanuel Saez also of Berkeley, and
Abhjit Banerjee of Princeton.
Roughly once every two weeks these
economists are polled on a question of
current policy or political interest—often it is
a question on which there are bitter divides
among politicians or the general public.
So what do we learn from the survey?
That there is much more agreement
among economists than rumor would
John D. and Catherine T.
MacArthur Foundation
When Economists Agree
FOR INQUIRING MINDS
Kelvin Ma
PA R T 1
Photo by Leah Horgan/J-Pal
42
clear ideological patterns when they did
disagree. Economists known to be liberals
did have slightly different positions, on
average, from those known to be conservatives, but the differences weren’t nearly as
large as those among the general public.
So is the stereotype of the quarreling
economists a myth? Not entirely:
economists do disagree quite a
lot on some issues, especially in
macroeconomics. But there is a large
area of common ground.
•
vehemently that the U.S. government should replace the income tax with a valueadded tax (a national sales tax, which is the main source of government revenue
in many European countries). Other equally respected economists disagree. Why
this difference of opinion?
One important source of differences lies in values: as in any diverse group
of individuals, reasonable people can differ. In comparison to an income tax, a
value-added tax typically falls more heavily on people of modest means. So an
economist who values a society with more social and income equality for its own
sake will tend to oppose a value-added tax. An economist with different values
will be less likely to oppose it.
A second important source of differences arises from economic modeling.
Because economists base their conclusions on models, which are simplified
representations of reality, two economists can legitimately disagree about which
simplifications are appropriate—and therefore arrive at different conclusions.
Suppose that the U.S. government were considering introducing a valueadded tax. Economist A may rely on a model that focuses on the administrative
costs of tax systems—that is, the costs of monitoring, processing papers, collecting the tax, and so on. This economist might then point to the well-known
high costs of administering a value-added tax and argue against the change. But
economist B may think that the right way to approach the question is to ignore
the administrative costs and focus on how the proposed law would change savings behavior. This economist might point to studies suggesting that value-added
taxes promote higher consumer saving, a desirable result.
Because the economists have used different models—that is, made different
simplifying assumptions—they arrive at different conclusions. And so the two
economists may find themselves on different sides of the issue.
CHAPTER 2
ECONOMIC MODELS: TR ADE-OFFS AND TR ADE
In most cases such disputes are eventually resolved by the accumulation of
evidence showing which of the various models proposed by economists does
a better job of fitting the facts. However, in economics, as in any science, it
can take a long time before research settles important disputes—decades, in
some cases. And since the economy is always changing, in ways that make
old models invalid or raise new policy questions, there are always new issues
on which economists disagree. The policy maker must then decide which
economist to believe.
The important point is that economic analysis is a method, not a set of conclusions.
s
ECONOMICS
in Action
Economists, Beyond the Ivory Tower
M
any economists are mainly engaged in teaching and research. But quite a
few economists have a more direct hand in events.
As described earlier in this chapter (For Inquiring Minds,
“The Model That Ate the Economy”), one specific branch of economics,
finance theory, plays an important role for financial firms on Wall Street—
not always to good effect. But pricing assets is by no means the only
useful function economists serve in the business world. Businesses need
forecasts of the future demand for their products, predictions of future rawmaterial prices, assessments of their future financing needs, and more; for all of
these purposes, economic analysis is essential.
Some of the economists employed in the business world work directly for the
institutions that need their input. Top financial firms like Goldman Sachs and
Morgan Stanley, in particular, maintain high-quality economics groups, which
produce analyses of forces and events likely to affect financial markets. Other
economists are employed by consulting firms like Macro Advisers, which sells
analysis and advice to a wide range of other businesses.
Last but not least, economists participate extensively in government.
According to the Bureau of Labor Statistics, government agencies employ about
half of the professional economists in the United States. This shouldn’t be
surprising: one of the most important functions of government is to make economic policy, and almost every government policy decision must take economic
effects into consideration. So governments around the world employ economists
in a variety of roles.
In the U.S. government, a key role is played by the Council of Economic
Advisers, whose sole purpose is to advise the president on economic matters.
Unlike most government employees, most economists at the Council aren’t longtime civil servants; instead, they are mainly professors on leave for one or two
years from their universities. Many of the nation’s best-known economists have
served at the Council of Economic Advisers at some point in their careers.
Economists also play an important role in many other parts of the government, from the Department of Commerce to the Labor Department. Economists
dominate the staff of the Federal Reserve, a government agency that controls the
economy’s money supply and oversees banks. And economists play an especially
important role in two international organizations headquartered in Washington,
D.C.: the International Monetary Fund, which provides advice and loans to countries experiencing economic difficulties, and the World Bank, which provides
advice and loans to promote long-term economic development.
In the past, it wasn’t that easy to track what all these economists working on practical affairs were up to. These days, however, there are very lively
online discussions of economic prospects and policy. See, for example, the
home page of the International Monetary Fund (www.imf.org), a business-
43
44
PA R T 1
W H AT I S E C O N O M I C S ?
Quick Review
• Positive economics—the
focus of most economic
research—is the analysis of
the way the world works, in
which there are definite right
and wrong answers. It often
involves making forecasts.
But in normative economics,
which makes prescriptions
about how things ought to
be, there are often no right
answers and only value
judgments.
• Economists do disagree—
though not as much as legend
has it—for two main reasons.
One, they may disagree about
which simplifications to make
in a model. Two, economists
may disagree—like everyone
else—about values.
oriented site like economy.com, and the blogs of individual economists, like Mark
Thoma (economistsview.typepad.com) or, yes, our own blog, which is among the
Technorati top 100 blogs, at krugman.blogs.nytimes.com.
Check Your Understanding
2-2
1. Which of the following statements is a positive statement? Which is a normative
statement?
a. Society should take measures to prevent people from engaging in dangerous
personal behavior.
b. People who engage in dangerous personal behavior impose higher costs on society through higher medical costs.
2. True or false? Explain your answer.
a. Policy choice A and policy choice B attempt to achieve the same social goal.
Policy choice A, however, results in a much less efficient use of resources than
policy choice B. Therefore, economists are more likely to agree on choosing
policy choice B.
b. When two economists disagree on the desirability of a policy, it’s typically
because one of them has made a mistake.
c. Policy makers can always use economics to figure out which goals a society
should try to achieve.
Solutions appear at back of book.
W
RLD VIE
O
I
n the summer and fall of 2010, workers were rearranging the furniture in
Boeing’s final assembly plant in Everett, Washington, in preparation for the
production of the Boeing 767. It was a difficult and time-consuming process,
however, because the items of “furniture”—Boeing’s assembly equipment—
weighed on the order of 200 tons each. It was a necessary part of setting up a
production system based on “lean manufacturing,” also called “just-in-time”
production.
Lean manufacturing, pioneered by Toyota Motors of Japan, is
based on the practice of having parts arrive on the factory floor just
as they are needed for production. This reduces the amount of parts
Boeing holds in inventory as well as the amount of the factory floor
needed for production—in this case, reducing the square footage
required for manufacture of the 767 by 40%.
Boeing had adopted lean manufacturing in 1999 in the manufacture of the 737, the most popular commercial airplane. By 2005, after
constant refinement, Boeing had achieved a 50% reduction in the
time it takes to produce a plane and a nearly 60% reduction in parts
inventory. An important feature is a continuously moving assembly
line, moving products from one assembly team to the next at a steady
pace and eliminating the need for workers to wander across the factory floor from task to task or in search of tools and parts.
Toyota’s lean production techniques have been the most widely
adopted, revolutionizing manufacturing worldwide. In simple terms, lean production is focused on organization and communication. Workers and parts are
organized so as to ensure a smooth and consistent workflow that minimizes wasted effort and materials. Lean production is also designed to be highly responsive
to changes in the desired mix of output—for example, quickly producing more
sedans and fewer minivans according to changes in customer demand.
Toyota’s lean production methods were so successful that they transformed
the global auto industry and severely threatened once-dominant American automakers. Until the 1980s, the “Big Three”—Chrysler, Ford, and General Motors—
dominated the American auto industry, with virtually no foreign-made cars sold
in the United States. In the 1980s, however, Toyotas became increasingly popular
in the United States due to their high quality and relatively low price—so popular
that the Big Three eventually prevailed upon the U.S. government to protect them
by restricting the sale of Japanese autos in the U.S. Over time, Toyota responded
by building assembly plants in the United States, bringing along its lean production techniques, which then spread throughout American manufacturing.
Echo/Getty Images
CASE
Efficiency, Opportunity Cost and the
Logic of Lean Production
W
BUSINESS
QUESTIONS FOR THOUGHT
1. What is the opportunity cost associated with having a worker wander across
the factory floor from task to task or in search of tools and parts?
2. Explain how lean manufacturing improves the economy’s efficiency in allocation.
3. Before lean manufacturing innovations, Japan mostly sold consumer electronics to the United States. How did lean manufacturing innovations alter
Japan’s comparative advantage vis-à-vis the United States?
4. Predict how the shift in the location of Toyota’s production from Japan to the
United States is likely to alter the pattern of comparative advantage in automaking between the two countries.
45
46
PA R T 1
W H AT I S E C O N O M I C S ?
SUMMARY
1. Almost all economics is based on models, “thought
experiments” or simplified versions of reality, many
of which use mathematical tools such as graphs. An
important assumption in economic models is the other
things equal assumption, which allows analysis of
the effect of a change in one factor by holding all other
relevant factors unchanged.
2. One important economic model is the production
possibility frontier. It illustrates opportunity cost
(showing how much less of one good can be produced
if more of the other good is produced); efficiency (an
economy is efficient in production if it produces on the
production possibility frontier and efficient in allocation if it produces the mix of goods and services that
people want to consume); and economic growth (an
outward shift of the production possibility frontier).
There are two basic sources of growth: an increase in
factors of production—resources such as land, labor,
capital, and human capital, inputs that are not used up
in production—and improved technology.
3. Another important model is comparative advantage,
which explains the source of gains from trade between
individuals and countries. Everyone has a comparative advantage in something—some good or service in
which that person has a lower opportunity cost than
everyone else. But it is often confused with absolute
advantage, an ability to produce a particular good or
service better than anyone else. This confusion leads
some to erroneously conclude that there are no gains
from trade between people or countries.
4. In the simplest economies people barter—trade goods
and services for one another—rather than trade them
for money, as in a modern economy. The circular-flow
diagram represents transactions within the economy
as flows of goods, services, and money between households and firms. These transactions occur in markets
for goods and services and factor markets, markets
for factors of production—land, labor, physical capital, and human capital. It is useful in understanding
how spending, production, employment, income, and
growth are related in the economy. Ultimately, factor
markets determine the economy’s income distribution, how an economy’s total income is allocated to the
owners of the factors of production.
5. Economists use economic models for both positive
economics, which describes how the economy works,
and for normative economics, which prescribes how
the economy should work. Positive economics often
involves making forecasts. Economists can determine
correct answers for positive questions but typically
not for normative questions, which involve value judgments. The exceptions are when policies designed to
achieve a certain objective can be clearly ranked in
terms of efficiency.
6. There are two main reasons economists disagree. One,
they may disagree about which simplifications to make
in a model. Two, economists may disagree—like everyone else—about values.
KEY TERMS
Model, p. 26
Other things equal assumption, p. 27
Production possibility frontier, p. 27
Factors of production, p. 32
Technology, p. 32
Comparative advantage, p. 34
Absolute advantage, p. 36
Barter, p. 37
Circular-flow diagram, p. 37
Household, p. 38
Firm, p. 38
Markets for goods and services, p. 38
Factor markets, p. 38
Income distribution, p. 38
Positive economics, p. 40
Normative economics, p. 40
Forecast, p. 41
PROBLEMS
1. Two important industries on the island of Bermuda are
fishing and tourism. According to data from the Food
and Agriculture Organization of the United Nations and
the Bermuda Department of Statistics, in 2009 the 306
registered fishermen in Bermuda caught 387 metric
tons of marine fish. And the 2,719 people employed by
hotels produced 554,400 hotel stays (measured by the
number of visitor arrivals). Suppose that this production point is efficient in production. Assume also that
the opportunity cost of 1 additional metric ton of fish
is 2,000 hotel stays and that this opportunity cost is
constant (the opportunity cost does not change).
a. If all 306 registered fishermen were to be employed
by hotels (in addition to the 2,719 people already
working in hotels), how many hotel stays could
Bermuda produce?
b. If all 2,719 hotel employees were to become fish-
ermen (in addition to the 306 fishermen already
working in the fishing industry), how many metric
tons of fish could Bermuda produce?
CHAPTER 2
c. Draw a production possibility frontier for Bermuda,
with fish on the horizontal axis and hotel stays on
the vertical axis, and label Bermuda’s actual production point for the year 2009.
2. According to data from the U.S. Department of
Agriculture’s National Agricultural Statistics
Service, 124 million acres of land in the United
States were used for wheat or corn farming in a
recent year. Of those 124 million acres, farmers
used 50 million acres to grow 2.158 billion bushels
of wheat and 74 million acres to grow 11.807 billion
bushels of corn. Suppose that U.S. wheat and corn
farming is efficient in production. At that production point, the opportunity cost of producing 1
additional bushel of wheat is 1.7 fewer bushels of
corn. However, because farmers have increasing
opportunity costs, additional bushels of wheat have
an opportunity cost greater than 1.7 bushels of corn.
For each of the following production points, decide
whether that production point is (i) feasible and
efficient in production, (ii) feasible but not efficient
in production, (iii) not feasible, or (iv) unclear as to
whether or not it is feasible.
a. Farmers use 40 million acres of land to produce 1.8
billion bushels of wheat, and they use 60 million
acres of land to produce 9 billion bushels of corn.
The remaining 24 million acres are left unused.
b. From their original production point, farmers trans-
fer 40 million acres of land from corn to wheat production. They now produce 3.158 billion bushels of
wheat and 10.107 bushels of corn.
c. Farmers reduce their production of wheat to 2 bil-
lion bushels and increase their production of corn to
12.044 billion bushels. Along the production possibility frontier, the opportunity cost of going from 11.807
billion bushels of corn to 12.044 billion bushels of
corn is 0.666 bushel of wheat per bushel of corn.
3. In the ancient country of Roma, only two goods, spa-
ghetti and meatballs, are produced. There are two tribes
in Roma, the Tivoli and the Frivoli. By themselves, the
Tivoli each month can produce either 30 pounds of spaghetti and no meatballs, or 50 pounds of meatballs and
no spaghetti, or any combination in between. The Frivoli,
by themselves, each month can produce 40 pounds of
spaghetti and no meatballs, or 30 pounds of meatballs
and no spaghetti, or any combination in between.
a. Assume that all production possibility frontiers
are straight lines. Draw one diagram showing the
monthly production possibility frontier for the Tivoli
and another showing the monthly production possibility frontier for the Frivoli. Show how you calculated them.
b. Which tribe has the comparative advantage in spa-
ghetti production? In meatball production?
In a.d. 100 the Frivoli discover a new technique for
making meatballs that doubles the quantity of meatballs they can produce each month.
ECONOMIC MODELS: TR ADE-OFFS AND TR ADE
47
c. Draw the new monthly production possibility fron-
tier for the Frivoli.
d. After the innovation, which tribe now has an abso-
lute advantage in producing meatballs? In producing
spaghetti? Which has the comparative advantage in
meatball production? In spaghetti production?
4. One July, the United States sold aircraft worth $1 bil-
lion to China and bought aircraft worth only $19,000
from China. During the same month, however, the
United States bought $83 million worth of men’s
trousers, slacks, and jeans from China but sold only
$8,000 worth of trousers, slacks, and jeans to China.
Using what you have learned about how trade is determined by comparative advantage, answer the following questions.
a. Which country has the comparative advantage in
aircraft production? In production of trousers,
slacks, and jeans?
b. Can you determine which country has the absolute
advantage in aircraft production? In production of
trousers, slacks, and jeans?
5. Peter Pundit, an economics reporter, states that the
European Union (EU) is increasing its productivity very
rapidly in all industries. He claims that this productivity advance is so rapid that output from the EU in these
industries will soon exceed that of the United States
and, as a result, the United States will no longer benefit
from trade with the EU.
a. Do you think Peter Pundit is correct or not? If not,
what do you think is the source of his mistake?
b. If the EU and the United States continue to trade,
what do you think will characterize the goods that
the EU sells to the United States and the goods that
the United States sells to the EU?
6. You are in charge of allocating residents to your dor-
mitory’s baseball and basketball teams. You are down
to the last four people, two of whom must be allocated
to baseball and two to basketball. The accompanying
table gives each person’s batting average and freethrow average.
Name
Batting average
Free-throw average
Kelley
70%
60%
Jackie
50%
50%
Curt
10%
30%
Gerry
80%
70%
a. Explain how you would use the concept of com-
parative advantage to allocate the players. Begin by
establishing each player’s opportunity cost of free
throws in terms of batting average.
b. Why is it likely that the other basketball play-
ers will be unhappy about this arrangement
but the other baseball players will be satisfied?
Nonetheless, why would an economist say that this
is an efficient way to allocate players for your dormitory’s sports teams?
48
PA R T 1
W H AT I S E C O N O M I C S ?
7. The inhabitants of the fictional economy of Atlantis use
10. A representative of the American clothing industry
money in the form of cowry shells. Draw a circular-flow
diagram showing households and firms. Firms produce potatoes and fish, and households buy potatoes
and fish. Households also provide the land and labor
to firms. Identify where in the flows of cowry shells or
physical things (goods and services, or resources) each
of the following impacts would occur. Describe how
this impact spreads around the circle.
a. A devastating hurricane floods many of the potato
fields.
recently made the following statement: “Workers in
Asia often work in sweatshop conditions earning only
pennies an hour. American workers are more productive and as a result earn higher wages. In order to
preserve the dignity of the American workplace, the
government should enact legislation banning imports
of low-wage Asian clothing.”
a. Which parts of this quote are positive statements?
Which parts are normative statements?
b. A very productive fishing season yields a very large
the preceding statements about the wages and productivities of American and Asian workers?
number of fish caught.
c. The inhabitants of Atlantis discover Shakira and
spend several days a month at dancing festivals.
8. An economist might say that colleges and universi-
ties “produce” education, using faculty members and
students as inputs. According to this line of reasoning,
education is then “consumed” by households. Construct
a circular-flow diagram to represent the sector of the
economy devoted to college education: colleges and
universities represent firms, and households both consume education and provide faculty and students to
universities. What are the relevant markets in this diagram? What is being bought and sold in each direction?
What would happen in the diagram if the government
decided to subsidize 50% of all college students’ tuition?
9. Your dormitory roommate plays loud music most of the
time; you, however, would prefer more peace and quiet.
You suggest that she buy some earphones. She responds
that although she would be happy to use earphones, she
has many other things that she would prefer to spend
her money on right now. You discuss this situation with
a friend who is an economics major. The following
exchange takes place:
He: How much would it cost to buy earphones?
You: $15.
He: How much do you value having some peace and
quiet for the rest of the semester?
You: $30.
He: It is efficient for you to buy the earphones and give
them to your roommate. You gain more than you lose;
the benefit exceeds the cost. You should do that.
You: It just isn’t fair that I have to pay for the earphones
when I’m not the one making the noise.
a. Which parts of this conversation contain positive
statements and which parts contain normative
statements?
b. Construct an argument supporting your viewpoint
that your roommate should be the one to change
her behavior. Similarly, construct an argument from
the viewpoint of your roommate that you should be
the one to buy the earphones. If your dormitory has
a policy that gives residents the unlimited right to
play music, whose argument is likely to win? If your
dormitory has a rule that a person must stop playing music whenever a roommate complains, whose
argument is likely to win?
b. Is the policy that is being advocated consistent with
c. Would such a policy make some Americans better
off without making any other Americans worse off?
That is, would this policy be efficient from the viewpoint of all Americans?
d. Would low-wage Asian workers benefit from or be
hurt by such a policy?
11. Are the following statements true or false? Explain your
answers.
a. “When people must pay higher taxes on their wage
earnings, it reduces their incentive to work” is a
positive statement.
b. “We should lower taxes to encourage more work” is
a positive statement.
c. Economics cannot always be used to completely
decide what society ought to do.
d. “The system of public education in this country
generates greater benefits to society than the cost of
running the system” is a normative statement.
e. All disagreements among economists are generated
by the media.
12. Evaluate the following statement: “It is easier to build
an economic model that accurately reflects events that
have already occurred than to build an economic model
to forecast future events.” Do you think this is true or
not? Why? What does this imply about the difficulties
of building good economic models?
13. Economists who work for the government are often
called on to make policy recommendations. Why do you
think it is important for the public to be able to differentiate normative statements from positive statements
in these recommendations?
14. The mayor of Gotham City, worried about a potential epi-
demic of deadly influenza this winter, asks an economic
adviser the following series of questions. Determine
whether a question requires the economic adviser to
make a positive assessment or a normative assessment.
a. How much vaccine will be in stock in the city by the
end of November?
b. If we offer to pay 10% more per dose to the pharma-
ceutical companies providing the vaccines, will they
provide additional doses?
c. If there is a shortage of vaccine in the city, whom
should we vaccinate first—the elderly or the very
CHAPTER 2
young? (Assume that a person from one group has
an equal likelihood of dying from influenza as a person from the other group.)
d. If the city charges $25 per shot, how many people
will pay?
e. If the city charges $25 per shot, it will make a profit
of $10 per shot, money that can go to pay for inoculating poor people. Should the city engage in such a
scheme?
15. Assess the following statement: “If economists just had
enough data, they could solve all policy questions in a
way that maximizes the social good. There would be no
need for divisive political debates, such as whether the
government should provide free medical care for all.”
ECONOMIC MODELS: TR ADE-OFFS AND TR ADE
49
WORK IT OUT
For interactive, step-by-step help in solving the following problem,
visit
by using the URL on the back cover of this book.
16. Atlantis is a small, isolated island in the South
Atlantic. The inhabitants grow potatoes and catch
fish. The accompanying table shows the maximum
annual output combinations of potatoes and fish
that can be produced. Obviously, given their limited
resources and available technology, as they use more
of their resources for potato production, there are
fewer resources available for catching fish.
Maximum annual
output options
Quantity of
potatoes (pounds)
Quantity of
fish (pounds)
A
1,000
0
B
800
300
C
600
500
D
400
600
E
200
650
F
0
675
a. Draw a production possibility frontier with pota-
toes on the horizontal axis and fish on the vertical axis illustrating these options, showing
points A–F.
b. Can Atlantis produce 500 pounds of fish and
800 pounds of potatoes? Explain. Where would
this point lie relative to the production possibility
frontier?
c. What is the opportunity cost of increasing the
annual output of potatoes from 600 to 800
pounds?
d. What is the opportunity cost of increasing the
annual output of potatoes from 200 to 400
pounds?
e. Can you explain why the answers to parts c and d
are not the same? What does this imply about the
slope of the production possibility frontier?
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CHAPTER
Graphs in Economics
2
APPENDIX
Getting the Picture
Whether you’re reading about economics in the Wall Street Journal or in your
economics textbook, you will see many graphs. Visual images can make it much
easier to understand verbal descriptions, numerical information, or ideas. In
economics, graphs are the type of visual image used to facilitate understanding.
To fully understand the ideas and information being discussed, you need to be
familiar with how to interpret and construct these visual aids. This appendix
explains how to do this.
Graphs, Variables, and Economic Models
One reason to attend college is that a bachelor’s degree provides access to higher­­
paying jobs. Additional degrees, such as MBAs or law degrees, increase earnings
even more. If you were to read an article about the relationship between edu­
cational attainment and income, you would probably see a graph showing the
income levels for workers with different amounts of education. And this graph
would depict the idea that, in general, more education increases income.
This graph, like most of those in economics, would depict the relationship
between two economic variables. A variable is a quantity that can take on more
than one value, such as the number of years of education a person has, the price
of a can of soda, or a household’s income.
As you learned in this chapter, economic analysis relies heavily on models, sim­
plified descriptions of real situations. Most economic models describe the rela­
tionship between two variables, simplified by holding constant other variables
that may affect the relationship.
For example, an economic model might describe the relationship between
the price of a can of soda and the number of cans of soda that consumers will
buy, assuming that everything else affecting consumers’ purchases of soda stays
constant. This type of model can be described mathematically or verbally, but
illustrating the relationship in a graph makes it easier to understand, as you’ll
see next.
How Graphs Work
Most graphs in economics are based on a grid built around two perpendicular
lines that show the values of two variables, helping you visualize the relationship
between them. So a first step in understanding the use of such graphs is to see
how this system works.
Two­-­Variable Graphs
Figure 2A-1 shows a typical two­-­variable graph. It illustrates the data in the
accompanying table on outside temperature and the number of sodas a typical
vendor can expect to sell at a baseball stadium during one game. The first col­
umn shows the values of outside temperature (the first variable) and the second
column shows the values of the number of sodas sold (the second variable). Five
combinations or pairs of the two variables are shown, each denoted by A through
E in the third column.
Now let’s turn to graphing the data in this table. In any two­-­variable graph,
one variable is called the x-variable and the other is called the y-variable. Here
A quantity that can take on more
than one value is called a variable.
51
52
PA R T 1
W H AT I S E C O N O M I C S ?
Plotting Points on a Two-Variable Graph
FIGURE 2A-1
Number of
sodas sold
y
Vertical axis or y-axis
E
70
y-variable
is the
dependent
variable.
(80, 70)
60
D
50
(60, 50)
40
C
30
(40, 30)
x-variable
outside
temperature
y-variable
number of
sodas sold
Point
0 °F
10
A
10
0
B
40
30
C
60
50
D
80
70
E
20
10
Origin
(0, 0)
0
A (0, 10)
Horizontal axis
or x-axis
B (10, 0)
10
20 30 40 50 60 70 80 90
Outside temperature (degrees Fahrenheit)
The data from the table are plotted where outside
temperature (the independent variable) is measured
along the horizontal axis and number of sodas sold (the
dependent variable) is measured along the vertical axis.
Each of the five combinations of temperature and sodas
The line along which values of the
x­-­variable are measured is called the
horizontal axis or x­-­axis. The line
along which values of the y­-­variable
are measured is called the vertical
axis or y­-­axis. The point where the
axes of a two­-­variable graph meet is
the origin.
A causal relationship exists
between two variables when the
value taken by one variable directly
influences or determines the value
taken by the other variable. In a
causal relationship, the determining
variable is called the independent
variable; the variable it determines
is called the dependent variable.
x
x-variable is
the independent
variable.
sold is represented by a point: A, B, C, D, and E. Each
point in the graph is identified by a pair of values. For
example, point C corresponds to the pair (40, 30)—an
outside temperature of 40°F (the value of the x-variable)
and 30 sodas sold (the value of the y-variable).
we have made outside temperature the x-variable and number of sodas sold the
y-variable. The solid horizontal line in the graph is called the horizontal axis
or x-axis, and values of the x-variable—outside temperature—are measured
along it. Similarly, the solid vertical line in the graph is called the vertical axis
or y-axis, and values of the y-variable—number of sodas sold—are measured
along it.
At the origin, the point where the two axes meet, each variable is equal to
zero. As you move rightward from the origin along the x-axis, values of the
x-variable are positive and increasing. As you move up from the origin along the
y-axis, values of the y-variable are positive and increasing.
You can plot each of the five points A through E on this graph by using a pair
of numbers—the values that the x-variable and the y-variable take on for a given
point. In Figure 2A-1, at point C, the x-variable takes on the value 40 and the
y-variable takes on the value 30. You plot point C by drawing a line straight up
from 40 on the x-axis and a horizontal line across from 30 on the y-axis. We write
point C as (40, 30). We write the origin as (0, 0).
Looking at point A and point B in Figure 2A-1, you can see that when one of the
variables for a point has a value of zero, it will lie on one of the axes. If the value
of the x-variable is zero, the point will lie on the vertical axis, like point A. If the
value of the y-variable is zero, the point will lie on the horizontal axis, like point B.
Most graphs that depict relationships between two economic variables repre­
sent a causal relationship, a relationship in which the value taken by one variable
directly influences or determines the value taken by the other variable. In a causal
relationship, the determining variable is called the independent variable; the
variable it determines is called the dependent variable. In our example of soda
CHAPTER 2
A P P E N D I X : GRAPHS IN ECONOMICS
sales, the outside temperature is the independent variable. It directly influences the
number of sodas that are sold, the dependent variable in this case.
By convention, we put the independent variable on the horizontal axis and the
dependent variable on the vertical axis. Figure 2A-1 is constructed consistent with
this convention; the independent variable (outside temperature) is on the horizon­
tal axis and the dependent variable (number of sodas sold) is on the vertical axis.
An important exception to this convention is in graphs showing the economic
relationship between the price of a product and quantity of the product: although
price is generally the independent variable that determines quantity, it is always
measured on the vertical axis.
A curve is a line on a graph that
depicts a relationship between two
variables. It may be either a straight
line or a curved line. If the curve is
a straight line, the variables have a
linear relationship. If the curve is
not a straight line, the variables have
a nonlinear relationship.
Curves on a Graph
Panel (a) of Figure 2A-2 contains some of the same information as Figure 2A-1,
with a line drawn through the points B, C, D, and E. Such a line on a graph is
called a curve, regardless of whether it is a straight line or a curved line. If the
curve that shows the relationship between two variables is a straight line, or
linear, the variables have a linear relationship. When the curve is not a straight
line, or nonlinear, the variables have a nonlinear relationship.
A point on a curve indicates the value of the y-variable for a specific value of
the x-variable. For example, point D indicates that at a temperature of 60°F, a
vendor can expect to sell 50 sodas. The shape and orientation of a curve reveal
FIGURE 2A-2
Drawing Curves
(a) Positive Linear Relationship
Number of
sodas sold
(b) Negative Linear Relationship
(80, 70)
E
70
60
(60, 50)
D
50
40
(40, 30)
C
30
20
10
Number of
hot drinks
sold
J (0, 70)
70
K (20, 50)
40
30
L (40, 30)
20
(10, 0)
Horizontal intercept
10
10 20 30 40 50 60 70 80
Outside temperature (degrees Fahrenheit)
The curve in panel (a) illustrates the relationship between the
two variables, outside temperature and number of sodas sold.
The two variables have a positive linear relationship: positive
because the curve has an upward tilt, and linear because it is a
straight line. It implies that an increase in the x-variable (outside
temperature) leads to an increase in the y-variable (number of
sodas sold). The curve in panel (b) is also a straight line, but
it tilts downward. The two variables here, outside temperature
(70, 0)
M
B
0
Vertical intercept
60
50
0
53
10 20 30 40 50 60 70 80
Outside temperature (degrees Fahrenheit)
and number of hot drinks sold, have a negative linear
relationship: an increase in the x-variable (outside temperature)
leads to a decrease in the y-variable (number of hot drinks
sold). The curve in panel (a) has a horizontal intercept at point
B, where it hits the horizontal axis. The curve in panel (b) has a
vertical intercept at point J, where it hits the vertical axis, and a
horizontal intercept at point M, where it hits the horizontal axis.
54
PA R T 1
W H AT I S E C O N O M I C S ?
Two variables have a positive
relationship when an increase
in the value of one variable is
associated with an increase in the
value of the other variable. It is
illustrated by a curve that slopes
upward from left to right.
Two variables have a negative
relationship when an increase
in the value of one variable is
associated with a decrease in the
value of the other variable. It is
illustrated by a curve that slopes
downward from left to right.
The horizontal intercept of a
curve is the point at which it hits the
horizontal axis; it indicates the value
of the x­-­variable when the value of
the y­-­variable is zero.
The vertical intercept of a curve
is the point at which it hits the
vertical axis; it shows the value of
the y­-­variable when the value of the
x­-­variable is zero.
The slope of a line or curve is a
measure of how steep it is. The
slope of a line is measured by
“rise over run”—the change in the
y­-­variable between two points on
the line divided by the change in
the x­-­variable between those same
two points.
the general nature of the relationship between the two variables. The upward tilt
of the curve in panel (a) of Figure 2A-2 means that vendors can expect to sell more
sodas at higher outside temperatures.
When variables are related this way—that is, when an increase in one variable
is associated with an increase in the other variable—the variables are said to have
a positive relationship. It is illustrated by a curve that slopes upward from left
to right. Because this curve is also linear, the relationship between outside tem­
perature and number of sodas sold illustrated by the curve in panel (a) of Figure
2A-2 is a positive linear relationship.
When an increase in one variable is associated with a decrease in the other
variable, the two variables are said to have a negative relationship. It is illus­
trated by a curve that slopes downward from left to right, like the curve in panel
(b) of Figure 2A-2. Because this curve is also linear, the relationship it depicts is
a negative linear relationship. Two variables that might have such a relationship
are the outside temperature and the number of hot drinks a vendor can expect to
sell at a baseball stadium.
Return for a moment to the curve in panel (a) of Figure 2A-2 and you can see
that it hits the horizontal axis at point B. This point, known as the horizontal
intercept, shows the value of the x-variable when the value of the y-variable is
zero. In panel (b) of Figure 2A-2, the curve hits the vertical axis at point J. This
point, called the vertical intercept, indicates the value of the y-variable when the
value of the x-variable is zero.
A Key Concept: The Slope of a Curve
The slope of a curve is a measure of how steep it is and indicates how sensitive
the y-variable is to a change in the x-variable. In our example of outside tempera­
ture and the number of cans of soda a vendor can expect to sell, the slope of the
curve would indicate how many more cans of soda the vendor could expect to
sell with each 1 degree increase in temperature. Interpreted this way, the slope
gives meaningful information. Even without numbers for x and y, it is possible to
arrive at important conclusions about the relationship between the two variables
by examining the slope of a curve at various points.
The Slope of a Linear Curve
Along a linear curve the slope, or steepness, is measured by dividing the “rise”
between two points on the curve by the “run” between those same two points.
The rise is the amount that y changes, and the run is the amount that x changes.
Here is the formula:
Change in y Δy
=
= Slope
Change in x Δx
In the formula, the symbol Δ (the Greek uppercase delta) stands for “change
in.” When a variable increases, the change in that variable is positive; when a vari­
able decreases, the change in that variable is negative.
The slope of a curve is positive when the rise (the change in the y-variable) has
the same sign as the run (the change in the x-variable). That’s because when two
numbers have the same sign, the ratio of those two numbers is positive. The curve
in panel (a) of Figure 2A-2 has a positive slope: along the curve, both the y-variable
and the x-variable increase.
The slope of a curve is negative when the rise and the run have different signs.
That’s because when two numbers have different signs, the ratio of those two num­
bers is negative. The curve in panel (b) of Figure 2A-2 has a negative slope: along the
curve, an increase in the x-variable is associated with a decrease in the y-variable.
Figure 2A-3 illustrates how to calculate the slope of a linear curve. Let’s focus
first on panel (a). From point A to point B the value of the y-variable changes from
CHAPTER 2
Calculating the Scope
FIGURE 2A-3
(a) Negative Constant Slope
y
(b) Positive Constant Slope
y
30
60
A
25
Slope = – 21
∆y = –5
20
5
10
10
15
20
25
30
35
40
45 x
0
∆y = 20
C
30
10
5
Slope = 5
40
∆x = 10
15
D
50
B
20
0
A P P E N D I X : GRAPHS IN ECONOMICS
A
∆y = 10
∆x = 2
1
2
∆x = 4
B
Slope = 5
3
4
5
6
7
8
9
10 x
Panels (a) and (b) show two linear curves. Between points A
The slope is positive, indicating that the curve is upward sloping.
and B on the curve in panel (a), the change in y (the rise) is −5
Furthermore, the slope between A and B is the same as the
and the change in x (the run) is 10. So the slope from A to B is
slope between C and D, making this a linear curve. The slope of
Δy
−5
1
=
= − = −0.5, where the negative sign indicates that the
2
Δx 10
a linear curve is constant: it is the same regardless of where it is
curve is downward sloping. In panel (b), the curve has a slope
measured along the curve.
Δy
Δy
10
20
from A to B of
=
= 5. The slope from C to D is
=
= 5.
2
4
Δx
Δx
25 to 20 and the value of the x-variable changes from 10 to 20. So the slope of the
line between these two points is:
Change in y Δy −5
1
=
=
=−
= −0.5
2
Change in x Δx 10
Because a straight line is equally steep at all points, the slope of a straight line
is the same at all points. In other words, a straight line has a constant slope. You
can check this by calculating the slope of the linear curve between points A and
B and between points C and D in panel (b) of Figure 2A-3.
Between A and B:
Δy 10
=
=5
2
Δx
Between C and D:
Δy 20
=
=5
4
Δx
Horizontal and Vertical Curves and Their Slopes
When a curve is horizontal, the value of the y-variable along that curve never
changes—it is constant. Everywhere along the curve, the change in y is zero. Now,
zero divided by any number is zero. So, regardless of the value of the change in
x, the slope of a horizontal curve is always zero.
If a curve is vertical, the value of the x-variable along the curve never changes—
it is constant. Everywhere along the curve, the change in x is zero. This means that
the slope of a vertical curve is a ratio with zero in the denominator. A ratio with
zero in the denominator is equal to infinity—that is, an infinitely large number. So
the slope of a vertical curve is equal to infinity.
55
56
PA R T 1
W H AT I S E C O N O M I C S ?
A nonlinear curve is one in which
the slope is not the same between
every pair of points.
The absolute value of a negative
number is the value of the negative
number without the minus sign.
A vertical or a horizontal curve has a special implication: it means that the
x-variable and the y-variable are unrelated. Two variables are unrelated when a
change in one variable (the independent variable) has no effect on the other vari­
able (the dependent variable). Or to put it a slightly different way, two variables are
unrelated when the dependent variable is constant regardless of the value of the
independent variable. If, as is usual, the y-variable is the dependent variable, the
curve is horizontal. If the depen­dent variable is the x-variable, the curve is vertical.
The Slope of a Nonlinear Curve
A nonlinear curve is one in which the slope changes as you move along it.
Panels (a), (b), (c), and (d) of Figure 2A-4 show various nonlinear curves.
Panels (a) and (b) show nonlinear curves whose slopes change as you move
along them, but the slopes always remain positive. Although both curves tilt
upward, the curve in panel (a) gets steeper as you move from left to right in
contrast to the curve in panel (b), which gets flatter.
A curve that is upward sloping and gets steeper, as in panel (a), is said to have
positive increasing slope. A curve that is upward sloping but gets flatter, as in
panel (b), is said to have positive decreasing slope.
When we calculate the slope along these nonlinear curves, we obtain dif­
ferent values for the slope at different points. How the slope changes along the
curve determines the curve’s shape. For example, in panel (a) of Figure 2A-4,
the slope of the curve is a positive number that steadily increases as you move
from left to right, whereas in panel (b), the slope is a positive number that
steadily decreases.
The slopes of the curves in panels (c) and (d) are negative numbers. Economists
often prefer to express a negative number as its absolute value, which is the value
of the negative number without the minus sign. In general, we denote the abso­
lute value of a number by two parallel bars around the number; for example, the
absolute value of −4 is written as |−4| = 4.
In panel (c), the absolute value of the slope steadily increases as you move
from left to right. The curve therefore has negative increasing slope. And in panel
(d), the absolute value of the slope of the curve steadily decreases along the curve.
This curve therefore has negative decreasing slope.
Calculating the Slope Along a Nonlinear Curve
We’ve just seen that along a nonlinear curve, the value of the slope depends on
where you are on that curve. So how do you calculate the slope of a nonlinear
curve? We will focus on two methods: the arc method and the point method.
The Arc Method of Calculating the Slope An arc of a curve is some piece
or segment of that curve. For example, panel (a) of Figure 2A-4 shows an arc con­
sisting of the segment of the curve between points A and B. To calculate the slope
along a nonlinear curve using the arc method, you draw a straight line between
the two end­-­points of the arc. The slope of that straight line is a measure of the
average slope of the curve between those two end­-­points.
You can see from panel (a) of Figure 2A-4 that the straight line drawn between
points A and B increases along the x-axis from 6 to 10 (so that Δx = 4) as it
increases along the y-axis from 10 to 20 (so that Δy = 10). Therefore the slope of
the straight line connecting points A and B is:
Δy 10
=
= 2.5
4
Δx
This means that the average slope of the curve between points A and B is 2.5.
CHAPTER 2
Nonlinear Curves
FIGURE 2A-4
(a) Positive Increasing Slope
y
45
40
Positive slope
gets steeper.
30
20
0
1
2
3
4
5
6
8
45
A
40
9
10 11 12
x
Slope =
–3 13
20
C
15
2
3
4
5
6
8
∆y = –20
Slope =
–20
9
10 11 12
x
Negative slope
gets flatter.
B
10
5
8
9
panel (b) the slope of the curve from A to B is
10 11 12
y
x
=
x
10
= 2.5,
4
Δy 10
= = 10, and
1
Δx
Δy
5
2
= = 1 . The slope is positive and
3
Δx 3
decreasing; the curve gets flatter as you move to the right. In
it is
7
15
Δy
15
=
= 15. The slope is positive and
1
Δx
panel (c) the slope from A to B is
6
∆x = 1
20
increasing; the curve gets steeper as you move to the right. In
from C to D it is
5
A
25
∆x = 1
In panel (a) the slope of the curve from A to B is
and from C to D it is
4
(d) Negative Decreasing Slope
30
∆y = –15
7
3
35
Negative slope
gets steeper.
D
1
2
40
Slope = –15
5
1
45
B
10
0
y
∆x = 3
35
25
∆x = 1
10
5
∆y = –10
30
A
15
(c) Negative Increasing Slope
y
0
7
Positive slope
gets flatter.
∆y = 10
20
∆x = 4
5
∆x = 3
25
∆y = 10
A
10
30
∆x = 1
∆y = 5
Slope =
10
B
35
B
C
40
C
Slope = 2.5
15
D
D
2
Slope = 1 3
45
Slope = 15
25
(b) Positive Decreasing Slope
y
∆y = 15
35
57
A P P E N D I X : GRAPHS IN ECONOMICS
Δy −10
1
=
= −3 , and from C to D
3
3
Δx
Δy −15
=
= −15. The slope is negative and increasing; the
1
Δx
Slope = –1 23
1
0
2
3
4
5
∆x = 3
∆y = –5
D
6
7
8
9
10 11 12
x
curve gets steeper as you move to the right. And in panel (d) the
slope from A to B is
2
3
Δy −20
Δy
−5
=
= −20, and from C to D it is
=
1
3
Δx
Δx
= −1 . The slope is negative and decreasing; the curve gets
flatter as you move to the right. The slope in each case has been
calculated by using the arc method—that is, by drawing a
straight line connecting two points along a curve. The average
slope between those two points is equal to the slope of the
straight line between those two points.
Now consider the arc on the same curve between points C and D. A straight
line drawn through these two points increases along the x-axis from 11 to 12
(Δx = 1) as it increases along the y-axis from 25 to 40 (Δy = 15). So the average
slope between points C and D is:
Δy 15
=
= 15
1
Δx
C
58
PA R T 1
W H AT I S E C O N O M I C S ?
Therefore the average slope between points C and D is larger than the average
slope between points A and B. These calculations verify what we have already
observed—that this upward­-­tilted curve gets steeper as you move from left to
right and therefore has positive increasing slope.
A tangent line is a straight line
that just touches, or is tangent to, a
nonlinear curve at a particular point.
The slope of the tangent line is equal
to the slope of the nonlinear curve at
that point.
The Point Method of Calculating the Slope The point method calculates
the slope of a nonlinear curve at a specific point on that curve. Figure 2A-5 illus­
trates how to calculate the slope at point B on the curve. First, we draw a straight
line that just touches the curve at point B. Such a line is called a tangent line:
the fact that it just touches the curve at point B and does not touch the curve at
any other point on the curve means that the straight line is tangent to the curve
at point B. The slope of this tangent line is equal to the slope of the nonlinear
curve at point B.
You can see from Figure 2A-5 how the slope of the tangent line is calculated:
from point A to point C, the change in y is 15 and the change in x is 5, generating
a slope of:
Δy 15
=
=3
5
Δx
By the point method, the slope of the curve at point B is equal to 3.
A natural question to ask at this point is how to determine which method
to use—the arc method or the point method—in calculating the slope of a
nonlinear curve. The answer depends on the curve itself and the data used to
construct it.
You use the arc method when you don’t have enough information to be able
to draw a smooth curve. For example, suppose that in panel (a) of Figure 2A-4
you have only the data represented by points
A, C, and D and don’t have the data represent­
Calculating the Slope Using
ed by point B or any of the rest of the curve.
the Point Method
Clearly, then, you can’t use the point method
to calculate the slope at point B; you would
have to use the arc method to approximate
the slope of the curve in this area by drawing
Tangent
a straight line between points A and C.
line
But if you have sufficient data to draw the
smooth curve shown in panel (a) of Figure
2A-4, then you could use the point method to
C
calculate the slope at point B—and at every
Slope = 3
other point along the curve as well.
FIGURE 2A-5
y
25
20
15
B
∆y = 15
Maximum and Minimum Points
10
5
A
0
∆x = 5
1
2
3
4
5
6
7
x
Here a tangent line has been drawn, a line that just touches the curve
at point B. The slope of this line is equal to the slope of the curve at
point B. The slope of the tangent line, measuring from A to C, is
Δy 15
=
= 3.
5
Δx
The slope of a nonlinear curve can change
from positive to negative or vice versa. When
the slope of a curve changes from positive to
negative, it creates what is called a maximum
point of the curve. When the slope of a curve
changes from negative to positive, it creates a
minimum point.
Panel (a) of Figure 2A-6 illustrates a curve
in which the slope changes from positive to
negative as you move from left to right. When
x is between 0 and 50, the slope of the curve
is positive. At x equal to 50, the curve attains
CHAPTER 2
FIGURE 2A-6
A P P E N D I X : GRAPHS IN ECONOMICS
59
Maximum and Minimum Points
(a) Maximum
(b) Minimum
y
y
Maximum point
Minimum point
0
x
50
y increases as
x increases.
y decreases as
x increases.
Panel (a) shows a curve with a maximum point, the point
at which the slope changes from positive to negative.
0
y decreases as
x increases.
y increases as
x increases.
Panel (b) shows a curve with a minimum point, the point
at which the slope changes from negative to positive.
its highest point—the largest value of y along the curve. This point is called the
maximum of the curve. When x exceeds 50, the slope becomes negative as the
curve turns downward. Many important curves in economics, such as the curve
that represents how the profit of a firm changes as it produces more output, are
hill­-­shaped like this.
In contrast, the curve shown in panel (b) of Figure 2A-6 is U-shaped: it has a slope
that changes from negative to positive. At x equal to 50, the curve reaches its lowest
point—the smallest value of y along the curve. This point is called the minimum of the
curve. Various important curves in economics, such as the curve that represents how
per-unit the costs of some firms change as output increases, are U-shaped like this.
Calculating the Area Below
or Above a Curve
Sometimes it is useful to be able to measure the size of the area below or above
a curve. For the sake of simplicity, we’ll only calculate the area below or above a
linear curve.
How large is the shaded area below the linear curve in panel (a) of Figure
2A-7? First note that this area has the shape of a right triangle. A right triangle is
a triangle that has two sides that make a right angle with each other. We will refer
to one of these sides as the height of the triangle and the other side as the base of
the triangle. For our purposes, it doesn’t matter which of these two sides we refer
to as the base and which as the height.
Calculating the area of a right triangle is straightforward: multiply the height
of the triangle by the base of the triangle, and divide the result by 2. The height of
the triangle in panel (a) of Figure 2A-7 is 10 − 4 = 6. And the base of the triangle
is 3 − 0 = 3. So the area of that triangle is
6×3
=9
2
x
50
A nonlinear curve may have a
maximum point, the highest point
along the curve. At the maximum,
the slope of the curve changes from
positive to negative.
A nonlinear curve may have a
minimum point, the lowest point
along the curve. At the minimum,
the slope of the curve changes from
negative to positive.
60
PA R T 1
W H AT I S E C O N O M I C S ?
FIGURE 2A-7
Calculating the Area Below and Above a Linear Curve
(b) Area Above a Linear Curve
(a) Area Below a Linear Curve
Height of
triangle
= 10 – 4
=6
y
y
10
10
9
9
8
8
7
7
6
5
Height of
triangle
=8–2
=6
Area = 6 × 3 = 9
2
4
3
2
1
0
2
Area = 6 × 4 = 12
2
5
4
3
Base of
triangle =
3–0=3
1
6
Base of triangle
=4–0=4
2
1
3
4
5
x
0
1
2
3
The area above or below a linear curve forms a right triangle. The
2. In panel (a) the area of the shaded triangle is
area of a right triangle is calculated by multiplying the height of
panel (b) the area of the shaded triangle is
4
5
x
6×3
= 9. In
2
6×4
= 12.
2
the triangle by the base of the triangle, and dividing the result by
A time­-­series graph has dates
on the horizontal axis and values of
a variable that occurred on those
dates on the vertical axis.
How about the shaded area above the linear curve in panel (b) of Figure 2A-7?
We can use the same formula to calculate the area of this right triangle. The
height of the triangle is 8 − 2 = 6. And the base of the triangle is 4 − 0 = 4. So the
area of that triangle is
6×4
= 12
2
Graphs That Depict Numerical Information
Graphs can also be used as a convenient way to summarize and display data with­
out assuming some underlying causal relationship. Graphs that simply display
numerical information are called numerical graphs. Here we will consider four
types of numerical graphs: time­-­series graphs, scatter diagrams, pie charts, and
bar graphs. These are widely used to display real, empirical data about different
economic variables because they often help economists and policy makers identify
patterns or trends in the economy. But as we will also see, you must be aware of
both the usefulness and the limitations of numerical graphs to avoid misinterpret­
ing them or drawing unwarranted conclusions from them.
Types of Numerical Graphs
You have probably seen graphs that show what has happened over time to economic
variables such as the unemployment rate or stock prices. A time­-­series graph has
successive dates on the horizontal axis and the values of a variable that occurred on
those dates on the vertical axis.
For example, Figure 2A-8 shows real gross domestic product (GDP) per capita—
a rough measure of a country’s standard of living—in the United States from
1947 to 2013. A line connecting the points that correspond to real GDP per capita
CHAPTER 2
A P P E N D I X : GRAPHS IN ECONOMICS
for each calendar quarter during those years
FIGURE 2A-8
Time-Series Graph
gives a clear idea of the overall trend in the
standard of living over these years.
The U.S. Standard of Living, 1947–2013
Figure 2A-9 is an example of a different
kind of numerical graph. It represents infor­
Real GDP
per capita
mation from a sample of 181 countries on the
$50,000
standard of living, again measured by GDP
per capita, and the amount of carbon emis­
1981 1982
40,000
sions per capita, a measure of environmental
pollution. Each point here indicates an aver­
30,000
age resident’s standard of living and his or her
annual carbon emissions for a given country.
20,000
The points lying in the upper right of the
graph, which show combinations of a high
10,000
standard of living and high carbon emissions,
represent economically advanced countries
1947 1950 1960
1970
1980
1990
2000 2010 2013
such as the United States. (The country with
Year
the highest carbon emissions, at the top of the
graph, is Qatar.) Points lying in the bottom
left of the graph, which show combinations of
Time-series graphs show successive dates on the x-axis and values
a low standard of living and low carbon emis­
for a variable on the y-axis. This time-series graph shows real gross
sions, represent economically less advanced
domestic product per capita, a measure of a country’s standard of
countries such as Afghanistan and Sierra
living, in the United States from 1947 to late 2013.
Source: Bureau of Economic Analysis.
Leone.
The pattern of points indicates that there
is a positive relationship between living stan­
dard and carbon emissions per capita: on the whole, people create more pollu­
tion in countries with a higher standard of living.
A scatter diagram shows
This type of graph is called a scatter diagram, in which each point corre­
points that correspond to actual
sponds to an actual observation of the x-variable and the y-variable. In scatter
observations of the x­-­and
diagrams, a curve is typically fitted to the scatter of points; that is, a curve is
y­-­variables. A curve is usually
fitted to the scatter of points.
drawn that approximates as closely as possible the general relationship between
FIGURE 2A-9
Scatter Diagram
In a scatter diagram, each point
represents the corresponding
values of the x- and y-variables for a
given observation. Here, each point
indicates the GDP per capita and
the amount of carbon emissions
per capita for a given country for
a sample of 181 countries. The
upward-sloping fitted line here
is the best approximation of the
general relationship between the two
variables.
Source: World Bank.
Standard of Living and Carbon Emissions, 2010
CO2 emissions
per capita
(metric tons)
40
35
30
25
20
15
10
5
0
$10,000
30,000
50,000
70,000
90,000
GDP per capita
(2005, U.S. dollars)
61
62
PA R T 1
W H AT I S E C O N O M I C S ?
FIGURE 2A-10
Pie Chart
Education Levels of Workers Paid
at or Below Minimum Wage, 2012
Bachelor’s degree
or higher
8%
Less than
high school
diploma
28%
Some college,
or associate’s
degree
High school
35%
graduate, but
no college
30%
A pie chart shows the percentages of
a total amount that can be attributed
to various components. This pie chart
shows the percentages of workers
with given education levels who were
paid at or below the federal minimum
wage in 2012.
Source: Bureau of Labor Statistics.
the variables. As you can see, the fitted line in Figure 2A-9 is upward
sloping, indicating the underlying positive relationship between the two
variables. Scatter diagrams are often used to show how a general rela­
tionship can be inferred from a set of data.
A pie chart shows the share of a total amount that is accounted for
by various components, usually expressed in percentages. For example,
Figure 2A-10 is a pie chart that depicts the education levels of workers who
in 2012 were paid the federal minimum wage or less. As you can see, the
majority of workers paid at or below the minimum wage had no college
degree. Only 8% of workers who were paid at or below the minimum wage
had a bachelor’s degree or higher.
Bar graphs use bars of various heights or lengths to indicate values
of a variable. In the bar graph in Figure 2A-11, the bars show the percent
change in the number of unemployed workers in the United States from
2009 to 2010, separately for White, Black or African­-­A merican, and Asian
workers. Exact values of the variable that is being measured may be
written at the end of the bar, as in this figure. For instance, the number
of unemployed Black or African-American workers in the United States
increased by 9.4% between 2009 and 2010. But even without the precise
values, comparing the heights or lengths of the bars can give useful insight
into the relative magnitudes of the different values of the variable.
Problems in Interpreting Numerical Graphs
Although we’ve explained that graphs are visual images that make ideas
or information easier to understand, graphs can be constructed (intention­
ally or unintentionally) in ways that are misleading and can lead to inac­
curate conclusions. This section raises some issues to be aware of when
you are interpreting graphs.
Features of Construction Before drawing any conclusions about what a
numerical graph implies, pay close attention to the scale, or size of increments,
shown on the axes. Small increments tend to
visually exaggerate changes in the variables,
FIGURE 2A-11
Bar Graph
whereas large increments tend to visually
diminish them. So the scale used in construc­
Changes in the Number of Unemployed by Race (2009–2010)
tion of a graph can influence your interpre­
Percent change in
Change in number
tation of the significance of the changes it
number of unemployed
of unemployed
illustrates—perhaps in an unwarranted way.
Take, for example, Figure 2A-12, which
shows real GDP per capita in the United States
White
2.5%
268,000
from 1981 to 1982 using increments of $500.
You can see that real GDP per capita fell from
Black or
$28,936 to $27,839. A decrease, sure, but is it as
African9.4%
246,000
American
enormous as the scale chosen for the vertical
axis makes it seem?
If you go back and reexamine Figure 2A-8,
4.0%
21,000
Asian
which shows real GDP per capita in the United
States from 1947 to 2013, you can see that
this would be a misguided conclusion. Figure
2A-8 includes the same data shown in Figure
A bar graph measures a variable by using bars of various heights or
2A-12, but it is constructed with a scale having
lengths. This bar graph shows the percent change in the number of
increments of $10,000 rather than $500. From
unemployed workers between 2009 and 2010, separately for White,
it you can see that the fall in real GDP per
Black or African-American, and Asian workers.
capita from 1981 to 1982 was, in fact, relatively
Source: Bureau of Labor Statistics.
insignificant.
CHAPTER 2
FIGURE 2A-12
A P P E N D I X : GRAPHS IN ECONOMICS
63
Interpreting Graphs: The Effect of Scale
Some of the same data for the years
1981 and 1982 used in Figure
2A-8 are represented here, except
that here they are shown using
increments of $500 rather than
increments of $10,000. As a result of
this change in scale, changes in the
standard of living look much larger in
this figure compared to Figure 2A-8.
Source: Bureau of Economic Analysis
The U.S. Standard of Living, 1981–1982
Real GDP
per capita
$29,000
28,500
28,000
27,500
27,000
1981
1982
In fact, the story of real GDP per capita—a measure of the standard of living—
in the United States is mostly a story of ups, not downs. This comparison shows
that if you are not careful to factor in the choice of scale in interpreting a graph,
you can arrive at very different, and possibly misguided, conclusions.
Related to the choice of scale is the use of truncation in constructing a graph.
An axis is truncated when part of the range is omitted. This is indicated by two
slashes (//) in the axis near the origin. You can see that the vertical axis of Figure
2A-12 has been truncated—some of the range of values from 0 to $27,000 has
been omitted and a // appears in the axis. Truncation saves space in the presenta­
tion of a graph and allows smaller increments to be used in constructing it. As
a result, changes in the variable depicted on a graph that has been truncated
appear larger compared to a graph that has not been truncated and that uses
larger increments.
You must also consider exactly what a graph is illustrating. For example, in
Figure 2A-11, you should recognize that what is being shown are percent changes
in the number of unemployed, not numerical changes. The unemployment rate for
Black or African-American workers increased by the highest percentage, 9.4% in
this example. If you were to confuse numerical changes with percent changes,
you would erroneously conclude that the greatest number of newly unemployed
workers were Black or African-American.
In fact, a correct interpretation of Figure 2A-11 shows that the greatest num­
ber of newly unemployed workers were White: the total number of unemployed
White workers grew by 268,000, which is greater than the increase in the num­
ber of unemployed Black or African-American workers, which is 246,000 in this
example. Although there was a higher percentage increase in the number of unem­
ployed Black or African-American workers, the actual number of unemployed
Black or African-American workers in the United States in 2009 was smaller than
the number of unemployed White workers, leading to a smaller number of newly
unemployed Black or African-American workers than White workers.
Omitted Variables From a scatter diagram that shows two variables moving
either positively or negatively in relation to each other, it is easy to conclude that
there is a causal relationship. But relationships between two variables are not
always due to direct cause and effect. Quite possibly an observed relationship
between two variables is due to the unobserved effect of a third variable on each
of the other two variables.
Year
A pie chart shows how some total
is divided among its components,
usually expressed in percentages.
A bar graph uses bars of varying
height or length to show the
comparative sizes of different
observations of a variable.
An axis is truncated when some of
the values on the axis are omitted,
usually to save space.
64
PA R T 1
W H AT I S E C O N O M I C S ?
An omitted variable is an
unobserved variable that, through its
influence on other variables, creates
the erroneous appearance of a direct
causal relationship among those
variables.
The error of reverse causality is
committed when the true direction
of causality between two variables
is reversed.
An unobserved variable that, through its influence on other variables, creates
the erroneous appearance of a direct causal relationship among those variables
is called an omitted variable. For example, in New England, a greater amount
of snowfall during a given week will typically cause people to buy more snow
shovels. It will also cause people to buy more de­-­icer fluid. But if you omitted
the influence of the snowfall and simply plotted the number of snow shovels sold
versus the number of bottles of de­-­icer fluid sold, you would produce a scatter
diagram that showed an upward tilt in the pattern of points, indicating a positive
relationship between snow shovels sold and de­-­icer fluid sold.
To attribute a causal relationship between these two variables, however, is
misguided; more snow shovels sold do not cause more de­-­icer fluid to be sold, or
vice versa. They move together because they are both influenced by a third, deter­
mining, variable—the weekly snowfall, which is the omitted variable in this case.
So before assuming that a pattern in a scatter diagram implies a cause­-­and­-­
effect relationship, it is important to consider whether the pattern is instead the
result of an omitted variable. Or to put it succinctly: correlation is not causation.
Reverse Causality Even when you are confident that there is no omitted
variable and that there is a causal relationship between two variables shown in
a numerical graph, you must also be careful that you don’t make the mistake
of reverse causality—coming to an erroneous conclusion about which is the
dependent and which is the independent variable by reversing the true direction
of causality between the two variables.
For example, imagine a scatter diagram that depicts the grade point averages
(GPAs) of 20 of your classmates on one axis and the number of hours that each
classmate spends studying on the other. A line fitted between the points will
probably have a positive slope, showing a positive relationship between GPA and
hours of studying. We could reasonably infer that hours spent studying is the
independent variable and that GPA is the dependent variable. But you could make
the error of reverse causality: you could infer that a high GPA causes a student to
study more, whereas a low GPA causes a student to study less.
As you’ve just seen, it is important to understand how graphs can mislead or
be interpreted incorrectly. Policy decisions, business decisions, and political argu­
ments are often based on interpretation of the types of numerical graphs we’ve
just discussed. Problems of misleading features of construction, omitted vari­
ables, and reverse causality can lead to important and undesirable consequences.
CHAPTER 2
A P P E N D I X : GRAPHS IN ECONOMICS
65
PROBLEMS
measure the income tax rate? On which axis do you
measure income tax revenue?
1. Study the four accompanying diagrams. Consider
the following statements and indicate which diagram
matches each statement. Which variable would appear
on the horizontal and which on the vertical axis? In
each of these statements, is the slope positive, negative,
zero, or infinity?
Panel (a)
Panel (b)
Panel (c)
Panel (d)
b. What would tax revenue be at a 0% income tax rate?
c. The maximum possible income tax rate is 100%.
What would tax revenue be at a 100% income tax
rate?
d. Estimates now show that the maximum point on
the Laffer curve is (approximately) at a tax rate of
80%. For tax rates less than 80%, how would you
describe the relationship between the tax rate and
tax revenue, and how is this relationship reflected in
the slope? For tax rates higher than 80%, how would
you describe the relationship between the tax rate
and tax revenue, and how is this relationship reflect­
ed in the slope?
3. In the accompanying figures, the numbers on the axes
have been lost. All you know is that the units shown on
the vertical axis are the same as the units on the hori­
zontal axis.
y
Panel (a)
y
Panel (b)
a. If the price of movies increases, fewer consumers go
to see movies.
b. More experienced workers typically have higher
incomes than less experienced workers.
c. Whatever the temperature outside, Americans con­
sume the same number of hot dogs per day.
d. Consumers buy more frozen yogurt when the price
of ice cream goes up.
e. Research finds no relationship between the number
of diet books purchased and the number of pounds
lost by the average dieter.
f. Regardless of its price, Americans buy the same
quantity of salt.
2. During the Reagan administration, economist Arthur
Laffer argued in favor of lowering income tax rates in
order to increase tax revenues. Like most economists,
he believed that at tax rates above a certain level, tax
revenue would fall because high taxes would discour­
age some people from working and that people would
refuse to work at all if they received no income after
paying taxes. This relationship between tax rates and
tax revenue is graphically summarized in what is wide­
ly known as the Laffer curve. Plot the Laffer curve rela­
tionship assuming that it has the shape of a nonlinear
curve. The following questions will help you construct
the graph.
a. Which is the independent variable? Which is the
dependent variable? On which axis do you therefore
x
x
a. In panel (a), what is the slope of the line? Show that
the slope is constant along the line.
b. In panel (b), what is the slope of the line? Show that
the slope is constant along the line.
4. Answer each of the following questions by drawing a
schematic diagram.
a. Taking measurements of the slope of a curve at
three points farther and farther to the right along
the horizontal axis, the slope of the curve changes
from −0.3, to −0.8, to −2.5, measured by the point
method. Draw a schematic diagram of this curve.
How would you describe the relationship illustrated
in your diagram?
b. Taking measurements of the slope of a curve at five
points farther and farther to the right along the hor­
izontal axis, the slope of the curve changes from 1.5,
to 0.5, to 0, to −0.5, to −1.5, measured by the point
method. Draw a schematic diagram of this curve.
Does it have a maximum or a minimum?
5. For each of the accompanying diagrams, calculate the
8. An insurance company has found that the severity of
area of the shaded right triangle.
Panel (a)
y
5
100
4
80
3
60
2
40
1
20
1
0
2
3
4
x
0
Panel (c)
y
Panel (b)
y
5
10
40
8
30
15
20
25 x
Panel (d)
y
50
10
property damage in a fire is positively related to the
number of firefighters arriving at the scene.
a. Draw a diagram that depicts this finding with num­
ber of firefighters on the horizontal axis and amount
of property damage on the vertical axis. What is
the argument made by this diagram? Suppose you
reverse what is measured on the two axes. What is
the argument made then?
b. Should the insurance company ask the city to send
fewer firefighters to any fire in order to reduce its
payouts to policy holders?
9. This table illustrates annual salaries and income tax
owed by five individuals. Despite receiving different and
owing salaries and owe different amounts of income
tax, these five individuals are otherwise identical.
Name
Annual salary
Annual income ­
tax owed
Susan
$22,000
$3,304
Eduardo
63,000
14,317
John
3,000
454
6
Camila
94,000
23,927
20
4
Peter
37,000
7,020
10
2
a. If you were to plot these points on a graph, what would
10
0
20
30
40
50 x
0
1
2
3
4
5
6. The base of a right triangle is 10, and its area is 20.
What is the height of this right triangle?
7. The accompanying table shows the relationship between
workers’ hours of work per week and their hourly wage
rate. Apart from the fact that they receive a different
hourly wage rate and work different hours, these five
workers are otherwise identical.
be the average slope of the curve between the points for
Eduardo’s and Camila’s salaries and taxes using the arc
method? How would you interpret this value for slope?
b. What is the average slope of the curve between the
points for John’s and Susan’s salaries and taxes
using the arc method? How would you interpret that
value for slope?
c. What happens to the slope as salary increases? What
does this relationship imply about how the level of
income taxes affects a person’s incentive to earn a
higher salary?
Name
Quantity of labor
(hours per week)
Wage rate ­
(per hour)
Athena
30
$15
Boris
35
30
For interactive, step-by-step help in solving the following problem,
visit
by using the URL on the back cover of this book.
Curt
37
45
10. Studies have found a relationship between a country’s
Diego
36
60
Emily
32
75
a. Which variable is the independent variable? Which
is the dependent variable?
b. Draw a scatter diagram illustrating this relationship.
Draw a (non­linear) curve that connects the points.
Put the hourly wage rate on the vertical axis.
c. As the wage rate increases from $15 to $30, how
does the number of hours worked respond according
to the relationship depicted here? What is the aver­
age slope of the curve between Athena’s and Boris’s
data points using the arc method?
d. As the wage rate increases from $60 to $75, how
does the number of hours worked respond according
to the relationship depicted here? What is the aver­
age slope of the curve between Diego’s and Emily’s
data points using the arc method?
66
x
WORK IT OUT
yearly rate of economic growth and the yearly rate of
increase in airborne pollutants. It is believed that a
higher rate of economic growth allows a country’s resi­
dents to have more cars and travel more, thereby releas­
ing more air­borne pollutants.
a. Which variable is the independent variable?
Which is the dependent variable?
b. Suppose that in the country of Sudland, when the
yearly rate of economic growth fell from 3.0% to
1.5%, the yearly rate of increase in air­borne pol­
lutants fell from 6% to 5%. What is the average
slope of a non­linear curve between these points
using the arc method?
c. Assume that when the yearly rate of economic
growth rose from 3.5% to 4.5%, the yearly rate of
increase in air­borne pollutants rose from 5.5% to
7.5%. What is the average slope of a nonlinear curve
between these two points using the arc method?
d. How would you describe the relationship between
the two variables here?
CHAPTER
Supply and Demand
s
What You Will Learn
in This Chapter
RLD VIE
O
W
W
3
A NATURAL GAS BOOM
a competitive market is
•andWhat
how it is described by the
supply and demand model
What the demand curve and the
•supply
curve are
The difference between
•movements
along a curve and
equilibrium price and equilibrium
quantity
•
In the case of a shortage or
surplus, how price moves the
market back to equilibrium
P
AP Photo/Andrew Rush
How the supply and demand
•curves
determine a market’s
Spencer Platt/Getty Images
shifts of a curve
The adoption of new drilling technologies lead to cheaper natural gas and vigorous protests.
RESIDENT OBAMA GOT A VIVID
illustration of American free speech
in action while touring upstate New York
on August 23, 2013. The president was
greeted by more than 500 chanting and
sign-toting supporters and opponents.
Why the ruckus? Because upstate New
York is a key battleground over the adoption of a relatively new method of producing energy supplies. Hydraulic fracturing,
or fracking, is a method of extracting
natural gas (and to a lesser extent, oil)
from deposits trapped between layers of
shale rock thousands of feet underground
using—using powerful jets of chemicalladen water to release the gas. While it
has been known for almost a century that
the United States contains vast deposits
of natural gas within these shale formations, they lay untapped because drilling
for them was considered too difficult.
Until recently, that is. A few decades
ago, new drilling technologies were developed that made it possible to reach these
deeply embedded deposits. But what finally pushed energy companies to invest in
and adopt these new extraction technologies was the high price of natural gas over
the last decade. What accounted for these
high natural gas prices—a quadrupling
from 2002 to 2006? There were two principal factors—one reflecting the demand
for natural gas, the other the supply of
natural gas.
First, the demand side. In 2002, the
U.S. economy was mired in recession;
with economic activity low and job losses
high, people and businesses cut back
their energy consumption. For example,
to save money, homeowners turned down
their thermostats in winter and turned
them up in the summer. But by 2006, the
U.S. economy came roaring back, and
natural gas consumption rose. Second,
the supply side. In 2005, Hurricane
Katrina devastated the American Gulf
Coast, site of most of the country’s natural gas production at the time. So by 2006
the demand for natural gas had surged
while the supply of natural gas had been
severely curtailed. As a result, in 2006
natural gas prices peaked at around $14
per thousand cubic feet, up from around
$2 in 2002.
Fast-forward to 2013: natural gas prices once again fell to $2 per thousand
cubic feet. But this time it wasn’t a slow
economy that was the principal explanation, it was the use of the new technologies. “Boom,” “supply shock,” and
“game changer” was how energy experts
described the impact of these technologies on oil and natural gas production and prices. To illustrate, the United
States produced 8.13 trillion cubic feet of
natural gas from shale deposits in 2012,
nearly doubling the total from 2010. That
total increased again in 2013, to 9.35 trillion cubic feet of natural gas, making the
U.S. the world’s largest producer of both
oil and natural gas—overtaking both
Russia and Saudia Arabia.
The benefits of much lower natural gas
prices have not only led to lower heating costs for American consumers, they
have also cascaded through American
industries, particularly power generation
and transportation. Electricity-generating
power plants are switching from coal to
natural gas, and mass-transit vehicles are
switching from gasoline to natural gas. (You
can even buy an inexpensive kit to convert
your car from gasoline to natural gas.) The
effect has been so significant that many
European manufacturers, paying four times
more for gas than their U.S. rivals, have
been forced to relocate plants to American
soil to survive. In addition, the revived U.S.
natural gas industry has directly created
tens of thousands of new jobs.
67
68
PA R T 2
S U P P LY A N D D E M A N D
Yet the benefits of natural gas have
been accompanied by deep reservations
and controversy over the environmental
effects of fracking. While there are clear
environmental benefits from the shift by
consumers and industries to natural gas
(which burns cleaner than the other, heavily polluting fossil fuels, gasoline and coal),
fracking has sparked another set of environmental worries. One is the potential
for contamination of local groundwater
by chemicals used in fracking. Another
is that cheap natural gas may discourage
the adoption of more expensive renewable
energy sources like solar and wind power,
furthering our dependence upon fossil fuel.
So it was the face-off between these
interests—pro-fracking and anti-fracking—
that confronted President Obama that
August day. While we, the authors, do not
espouse one side or the other (believing
that science as well as economics should
provide guidance about the best course to
follow), we will use the recent history of the
U.S. natural gas industry to help illustrate
important economic concepts such as supply and demand, price effects, firms’ costs,
international trade, pollution, and government regulation, among others. We discuss
all of these topics in future chapters; we also
revisit the fracking debate, particularly in
Chapter 16, where we will learn about the
economics of energy and environmental
concerns.
But for this chapter we will stick to
the topic of supply and demand. How,
exactly, does the high price of natural
gas nearly a decade ago translate into
today’s switch to vehicles powered by
natural gas? The short answer is that it’s
a matter of supply and demand. But what
does that mean? Many people use “supply and demand” as a sort of catchphrase
to mean “the laws of the marketplace
at work.” To economists, however, the
concept of supply and demand has a
precise meaning: it is a model of how a
market behaves that is extremely useful
for understanding many—but not all—
markets.
In this chapter, we lay out the pieces
that make up the supply and demand
model, put them together, and show how
this model can be used.
Supply and Demand: A Model
of a Competitive Market
A competitive market is a market
in which there are many buyers and
sellers of the same good or service,
none of whom can influence the
price at which the good or service
is sold.
The supply and demand model
is a model of how a competitive
market behaves.
Natural gas sellers and natural gas buyers constitute a market—a group of
producers and consumers who exchange a good or service for payment. In this
chapter, we’ll focus on a particular type of market known as a competitive market.
A competitive market is a market in which there are many buyers and sellers of
the same good or service. More precisely, the key feature of a competitive market
is that no individual’s actions have a noticeable effect on the price at which the
good or service is sold. It’s important to understand, however, that this is not an
accurate description of every market.
For example, it’s not an accurate description of the market for cola beverages. That’s because in this market, Coca-Cola and Pepsi account for such a large
proportion of total sales that they are able to influence the price at which cola
beverages are bought and sold. But it is an accurate description of the market
for natural gas. The global marketplace for natural gas is so huge that even the
biggest U.S. driller for natural gas—Exxon Mobil—accounts for such a small
share of total global transactions that it is unable to influence the price at which
natural gas is bought and sold.
It’s a little hard to explain why competitive markets are different from other
markets until we’ve seen how a competitive market works. So let’s take a rain
check—we’ll return to that issue at the end of this chapter. For now, let’s just say
that it’s easier to model competitive markets than other markets. When taking
an exam, it’s always a good strategy to begin by answering the easier questions.
In this book, we’re going to do the same thing. So we will start with competitive
markets.
When a market is competitive, its behavior is well described by the supply
and demand model. Because many markets are competitive, the supply and
demand model is a very useful one indeed.
There are five key elements in this model:
• The demand curve
• The supply curve
CHAPTER 3
• The set of factors that cause the demand curve to shift and the set of factors
that cause the supply curve to shift
• The market equilibrium, which includes the equilibrium price and equilibrium
quantity
• The way the market equilibrium changes when the supply curve or demand
curve shifts
To understand the supply and demand model, we will examine each of these elements.
The Demand Curve
How much natural gas will American consumers want to buy in a given year? You
might at first think that we can answer this question by adding up the amounts
each American household and business consumes in that year. But that’s not
enough to answer the question, because how much natural gas Americans want
to buy depends upon the price of natural gas.
When the price of natural gas falls, as it did from 2006 to 2013, consumers
will generally respond to the lower price by using more natural gas—for example,
by turning up their thermostats to keep their houses warmer in the winter or
switching to vehicles powered by natural gas. In general, the amount of natural
gas, or of any good or service that people want to buy, depends upon the price.
The higher the price, the less of the good or service people want to purchase;
alternatively, the lower the price, the more they want to purchase.
So the answer to the question “How many units of natural gas do consumers
want to buy?” depends on the price of a unit of natural gas. If you don’t yet know
what the price will be, you can start by making a table of how many units of natural gas people would want to buy at a number of different prices. Such a table is
known as a demand schedule. This, in turn, can be used to draw a demand curve,
which is one of the key elements of the supply and demand model.
The Demand Schedule and the Demand Curve
A demand schedule is a table showing how much of a good or service consumers
will want to buy at different prices. At the right of Figure 3-1, we show a hypothetical demand schedule for natural gas. It’s expressed in BTUs (British thermal units),
a commonly used measure of quantity of natural gas. It’s a hypothetical demand
schedule—it doesn’t use actual data on American demand for natural gas.
According to the table, if a BTU of natural gas costs $3, consumers around
the world will want to purchase 10 trillion BTUs of natural gas over the course of
a year. If the price is $3.25 per BTU, they will want to buy only 8.9 trillion BTUs;
if the price is only $2.75 per BTU, they will want to buy 11.5 trillion BTUs. The
higher the price, the fewer BTUs of natural gas consumers will want to purchase.
So, as the price rises, the quantity demanded of natural gas—the actual amount
consumers are willing to buy at some specific price—falls.
The graph in Figure 3-1 is a visual representation of the information in the
table. (You might want to review the discussion of graphs in economics in the
appendix to Chapter 2.) The vertical axis shows the price of a BTU of natural gas
and the horizontal axis shows the quantity of natural gas in trillions of BTUs.
Each point on the graph corresponds to one of the entries in the table. The curve
that connects these points is a demand curve. A demand curve is a graphical
representation of the demand schedule, another way of showing the relationship
between the quantity demanded and price.
Note that the demand curve shown in Figure 3-1 slopes downward. This
reflects the inverse relationship between price and the quantity demanded: a higher price reduces the quantity demanded, and a lower price increases the quantity
S U P P LY A N D D E M A N D
69
A demand schedule shows
how much of a good or service
consumers will want to buy at
different prices.
The quantity demanded is the
actual amount of a good or service
consumers are willing to buy at some
specific price.
A demand curve is a graphical
representation of the demand
schedule. It shows the relationship
between quantity demanded and
price.
70
PA R T 2
S U P P LY A N D D E M A N D
FIGURE 3-1
The Demand Schedule and the Demand Curve
Price of
natural gas
(per BTU)
Demand Schedule for Natural Gas
Price of
natural gas
(per BTU)
Quantity of
natural gas
demanded
(trillions of BTUs)
$4.00
$4.00
7.1
3.75
3.75
7.5
3.50
3.50
8.1
3.25
3.25
8.9
3.00
3.00
10.0
2.75
11.5
2.50
14.2
2.75
2.50
0
As price rises,
the quantity
demanded falls.
7
9
Demand
curve, D
11
13
15
17
Quantity of natural gas
(trillions of BTUs)
The demand schedule for natural gas yields the
corresponding demand curve, which shows how much
of a good or service consumers want to buy at any given
price. The demand curve and the demand schedule
reflect the law of demand: as price rises, the quantity
demanded falls. Similarly, a fall in price raises the quantity
demanded. As a result, the demand curve is downward
sloping.
demanded. We can see this from the demand curve in Figure 3-1. As price falls,
we move down the demand curve and quantity demanded increases. And as price
increases, we move up the demand curve and quantity demanded falls.
In the real world, demand curves almost always do slope downward. (The
exceptions are so rare that for practical purposes we can ignore them.) Generally,
the proposition that a higher price for a good, other things equal, leads people to
demand a smaller quantity of that good is so reliable that economists are willing
to call it a “law”—the law of demand.
Shifts of the Demand Curve
The law of demand says that a
higher price for a good or service,
other things equal, leads people to
demand a smaller quantity of that
good or service.
Although natural gas prices in 2006 were higher than they had been in 2002,
U.S. consumption of natural gas was higher in 2006. How can we reconcile this
fact with the law of demand, which says that a higher price reduces the quantity
demanded, other things equal?
The answer lies in the crucial phrase other things equal. In this case, other
things weren’t equal: the U.S. economy had changed between 2002 and 2006 in
ways that increased the amount of natural gas demanded at any given price. For
one thing, the U.S. economy was much stronger in 2006 than in 2002. Figure 3-2
illustrates this phenomenon using the demand schedule and demand curve for
natural gas. (As before, the numbers in Figure 3-2 are hypothetical.)
The table in Figure 3-2 shows two demand schedules. The first is the demand
schedule for 2002, the same as shown in Figure 3-1. The second is the demand
CHAPTER 3
FIGURE 3-2
An Increase in Demand
Price of
natural gas
(per BTU)
Demand Schedules for Natural Gas
$4.00
3.75
3.25
3.00
2.75
0
Demand curve
in 2002
7
9
D1
11
Quantity of natural
gas demanded
(trillions of BTUs)
Price of
natural gas
(per BTU)
$4.00
3.75
3.50
3.25
3.00
2.75
2.50
Demand curve
in 2006
3.50
2.50
S U P P LY A N D D E M A N D
in 2002
7.1
7.5
8.1
8.9
10.0
11.5
14.2
in 2006
8.5
9.0
9.7
10.7
12.0
13.8
17.0
D2
13
15
17
Quantity of natural gas
(trillions of BTUs)
A strong economy is one factor that increases the demand for natural gas—a rise in the quantity demanded at any given
price. This is represented by the two demand schedules—one showing the demand in 2002 when the economy was weak,
the other showing the demand in 2006, when the economy was strong—and their corresponding demand curves. The
increase in demand shifts the demand curve to the right.
schedule for 2006. It differs from the 2002 schedule because of the stronger U.S.
economy, leading to an increase in the quantity of natural gas demanded at any
given price. So at each price the 2006 schedule shows a larger quantity demanded
than the 2002 schedule. For example, the quantity of natural gas consumers
GLOBAL
COMPARISION
F
Pay More, Pump Less
or a real-world illustration of the law of demand, consider how gasoline consumption varies according to the
prices consumers pay at the pump. Because of high taxes,
gasoline and diesel fuel are more than twice as expensive in
most European countries and in many East Asian countries
than in the United States. According to the law of demand,
this should lead Europeans to buy less gasoline than
Americans—and they do. As you can see from the figure,
per person, Europeans consume less than half as much fuel
as Americans, mainly because they drive smaller cars with
better mileage.
Prices aren’t the only factor affecting fuel consumption, but they’re probably the main cause of the difference
between European and American fuel consumption per
person.
Price of
gasoline
(per gallon)
Source: World Development Indicators and U.S. Energy Information Administration, 2013.
$9
8
7
6
5
4
3
2
1
0
United Kingdom
Italy
Japan
France
Germany
Korea
Canada
United States
0.2
0.4
0.6
0.8
1.0
1.2
1.4
Consumption of gasoline
(gallons per day per capita)
71
72
PA R T 2
S U P P LY A N D D E M A N D
A shift of the demand curve is a
change in the quantity demanded at
any given price, represented by the
shift of the original demand curve to
a new position, denoted by a new
demand curve.
A movement along the demand
curve is a change in the quantity
demanded of a good arising from a
change in the good’s price.
FIGURE 3-3
wanted to buy at a price of $3 per BTU increased from 10 trillion to 12 trillion
BTUs per year; the quantity demanded at $3.25 per BTU went from 8.9 trillion to
10.7 trillion, and so on.
What is clear from this example is that the changes that occurred between
2002 and 2006 generated a new demand schedule, one in which the quantity
demanded was greater at any given price than in the original demand schedule.
The two curves in Figure 3-2 show the same information graphically. As you
can see, the demand schedule for 2006 corresponds to a new demand curve,
D2, that is to the right of the demand schedule for 2002, D1. This shift of the
demand curve shows the change in the quantity demanded at any given price,
represented by the change in position of the original demand curve D1 to its
new location at D2.
It’s crucial to make the distinction between such shifts of the demand curve
and movements along the demand curve, changes in the quantity demanded
of a good arising from a change in that good’s price. Figure 3-3 illustrates the
difference.
The movement from point A to point B is a movement along the demand curve:
the quantity demanded rises due to a fall in price as you move down D1. Here, a
fall in the price of natural gas from $3.50 to $3 per BTU generates a rise in the
quantity demanded from 8.1 trillion to 10 trillion BTUs per year. But the quantity
demanded can also rise when the price is unchanged if there is an increase in
demand—a rightward shift of the demand curve. This is illustrated in Figure 3-3
by the shift of the demand curve from D1 to D2. Holding the price constant at
$3.50 per BTU, the quantity demanded rises from 8.1 trillion BTUs at point A on
D1 to 9.7 trillion BTUs at point C on D2.
When economists say “the demand for X increased” or “the demand for Y
decreased,” they mean that the demand curve for X or Y shifted—not that the
quantity demanded rose or fell because of a change in the price.
Movement Along the Demand Curve versus Shift of the Demand Curve
The rise in quantity demanded when
going from point A to point B reflects
a movement along the demand curve:
it is the result of a fall in the price
of the good. The rise in quantity
demanded when going from point A
to point C reflects a shift of the
demand curve: it is the result of a
rise in the quantity demanded at any
given price.
Price of
natural gas
(per BTU)
A shift of the
demand curve . . .
$4.00
3.75
A
3.50
. . . is not the
same thing as
a movement along
the demand curve.
C
3.25
B
3.00
2.75
2.50
0
D1
7
8.1
9.7
10
D2
13
15
17
Quantity of natural gas
(trillions of BTUs)
CHAPTER 3
S U P P LY A N D D E M A N D
73
P I T FA L L S
DEMAND VERSUS QUANTITY
DEMANDED
When economists say “an increase in
demand,” they mean a rightward shift of
the demand curve, and when they say
“a decrease in demand,” they mean a
leftward shift of the demand curve—that
is, when they’re being careful. In ordinary
speech most people, including professional economists, use the word demand
casually. For example, an economist
might say “the demand for air travel has
doubled over the past 15 years, partly
because of falling airfares” when he
or she really means that the quantity
demanded has doubled.
It’s OK to be a bit sloppy in ordinary
conversation. But when you’re doing
economic analysis, it’s important to make
the distinction between changes in the
quantity demanded, which involve movements along a demand curve, and shifts
of the demand curve (See Figure 3-3
for an illustration). Sometimes students
end up writing something like this: “If
demand increases, the price will go up,
but that will lead to a fall in demand,
which pushes the price down . . .” and
then go around in circles. If you make
a clear distinction between changes
in demand, which mean shifts of the
demand curve, and changes in quantity
demanded, which means movement
along the demand curve, you can avoid a
lot of confusion.
Understanding Shifts of the Demand Curve
Figure 3-4 illustrates the two basic ways in which demand curves can shift.
When economists talk about an “increase in demand,” they mean a rightward
shift of the demand curve: at any given price, consumers demand a larger
quantity of the good or service than before. This is shown by the rightward
shift of the original demand curve D1 to D2. And when economists talk about
a “decrease in demand,” they mean a leftward shift of the demand curve: at
any given price, consumers demand a smaller quantity of the good or service
than before. This is shown by the leftward shift of the original demand curve
D1 to D3.
What caused the demand curve for natural gas to shift? As we mentioned earlier, the reason was the stronger U.S. economy in 2006 compared to 2002. If you
think about it, you can come up with other factors that would be likely to shift the
demand curve for natural gas. For example, suppose that the price of heating oil
rises. This will induce some consumers, who heat their homes and businesses in
winter with heating oil, to switch to natural gas instead, increasing the demand
for natural gas.
FIGURE 3-4
Shifts of the Demand Curve
Any event that increases demand
shifts the demand curve to the
right, reflecting a rise in the quantity
demanded at any given price. Any
event that decreases demand
shifts the demand curve to the
left, reflecting a fall in the quantity
demanded at any given price.
Price
Increase
in demand
Decrease
in demand
D3
D1
D2
Quantity
74
PA R T 2
S U P P LY A N D D E M A N D
Two goods are substitutes if a
rise in the price of one of the goods
leads to an increase in the demand
for the other good.
Two goods are complements if a
rise in the price of one good leads
to a decrease in the demand for the
other good.
When a rise in income increases
the demand for a good—the normal
case—it is a normal good.
When a rise in income decreases
the demand for a good, it is an
inferior good.
Economists believe that there are five principal factors that shift the demand
curve for a good or service:
• Changes in the prices of related goods or services
• Changes in income
• Changes in tastes
• Changes in expectations
• Changes in the number of consumers
Although this is not an exhaustive list, it contains the five most important
factors that can shift demand curves. So when we say that the quantity of a
good or service demanded falls as its price rises, other things equal, we are in
fact stating that the factors that shift demand are remaining unchanged. Let’s
now explore, in more detail, how those factors shift the demand curve.
Changes in the Prices of Related Goods or Services Heating oil is what
economists call a substitute for natural gas. A pair of goods are substitutes if a
rise in the price of one good (heating oil) makes consumers more likely to buy
the other good (natural gas). Substitutes are usually goods that in some way
serve a similar function: coffee and tea, muffins and doughnuts, train rides and
air flights. A rise in the price of the alternative good induces some consumers to
purchase the original good instead of it, shifting demand for the original good to
the right.
But sometimes a rise in the price of one good makes consumers less willing to buy another good. Such pairs of goods are known as complements.
Complements are usually goods that in some sense are consumed together:
computers and software, cappuccinos and cookies, cars and gasoline.
Because consumers like to consume a good and its complement together, a
change in the price of one of the goods will affect the demand for its complement. In particular, when the price of one good rises, the demand for its
complement decreases, shifting the demand curve for the complement to the
left. So, for example, when the price of gasoline began to rise in 2009 from
under $3 per gallon to close to $4 per gallon in 2011, the demand for gasguzzling cars fell.
Changes in Income Why did the stronger economy in 2006 lead to an increase
in the demand for natural gas compared to the demand during the weak economy
of 2002? Because with the stronger economy, Americans had more income,
making them more likely to purchase more of most goods and services at any
given price. For example, with a higher income you are likely to keep your house
warmer in the winter than if your income is low.
And, the demand for natural gas, a major source of fuel for electricitygenerating power plants, is tied to the demand for other goods and services.
For example, businesses must consume power in order to provide goods
and services to households. So when the economy is strong and household
incomes are high, businesses will consume more electricity and, indirectly,
more natural gas.
Why do we say that people are likely to purchase more of “most goods,” not
“all goods”? Most goods are normal goods—the demand for them increases
when consumer income rises. However, the demand for some products falls when
income rises. Goods for which demand decreases when income rises are known
as inferior goods. Usually an inferior good is one that is considered less desirable
than more expensive alternatives—such as a bus ride versus a taxi ride. When
they can afford to, people stop buying an inferior good and switch their consumption to the preferred, more expensive alternative. So when a good is inferior, a
rise in income shifts the demand curve to the left. And, not surprisingly, a fall in
income shifts the demand curve to the right.
CHAPTER 3
One example of the distinction between normal and inferior goods that has
drawn considerable attention in the business press is the difference between socalled casual-dining restaurants such as Applebee’s or Olive Garden and fast-food
chains such as McDonald’s and KFC. When their incomes rise, Americans tend
to eat out more at casual-dining restaurants. However, some of this increased
dining out comes at the expense of fast-food venues—to some extent, people visit
McDonald’s less once they can afford to move upscale. So casual dining is a normal good, whereas fast-food consumption appears to be an inferior good.
Changes in Tastes Why do people want what they want? Fortunately, we don’t
need to answer that question—we just need to acknowledge that people have certain preferences, or tastes, that determine what they choose to consume and that
these tastes can change. Economists usually lump together changes in demand
due to fads, beliefs, cultural shifts, and so on under the heading of changes in
tastes or preferences.
For example, once upon a time men wore hats. Up until around World War II,
a respectable man wasn’t fully dressed unless he wore a dignified hat along with
his suit. But the returning GIs adopted a more informal style, perhaps due to the
rigors of the war. And President Eisenhower, who had been supreme commander
of Allied Forces before becoming president, often went hatless. After World
War II, it was clear that the demand curve for hats had shifted leftward, reflecting a decrease in the demand for hats.
Economists have relatively little to say about the forces that influence consumers’ tastes. (Although marketers and advertisers have plenty to say about
them!) However, a change in tastes has a predictable impact on demand. When
tastes change in favor of a good, more people want to buy it at any given price, so
the demand curve shifts to the right. When tastes change against a good, fewer
people want to buy it at any given price, so the demand curve shifts to the left.
Changes in Expectations When consumers have some choice about when to
make a purchase, current demand for a good is often affected by expectations
about its future price. For example, savvy shoppers often wait for seasonal sales—
say, buying next year’s holiday gifts during the post-holiday markdowns. In this
case, expectations of a future drop in price lead to a decrease in demand today.
Alternatively, expectations of a future rise in price are likely to cause an increase
in demand today.
For example, the fall in gas prices in recent years to around $2 per BTU has
spurred more consumers to switch to natural gas from other fuel types than
when natural gas fell to $2 per BTU in 2002. But why are consumers more willing
to switch now? Because in 2002, consumers didn’t expect the fall in the price of
natural gas to last—and they were right.
In 2002, natural gas prices fell because of the weak economy. That situation changed in 2006 when the economy came roaring back and the price of
natural gas rose dramatically. In contrast, consumers have come to expect
that the more recent fall in the price of natural gas will not be temporary
because it is based on a permanent change: the ability to tap much larger
deposits of natural gas.
Expected changes in future income can also lead to changes in demand: if
you expect your income to rise in the future, you will typically borrow today and
increase your demand for certain goods; if you expect your income to fall in the
future, you are likely to save today and reduce your demand for some goods.
Changes in the Number of Consumers Another factor that can cause a
change in demand is a change in the number of consumers of a good or service.
For example, population growth in the United States eventually leads to higher
demand for natural gas as more homes and businesses need to be heated in the
winter and cooled in the summer.
S U P P LY A N D D E M A N D
75
76
PA R T 2
S U P P LY A N D D E M A N D
An individual demand curve
illustrates the relationship between
quantity demanded and price for an
individual consumer.
FIGURE 3-5
Let’s introduce a new concept: the individual demand curve, which shows the
relationship between quantity demanded and price for an individual consumer.
For example, suppose that the Gonzalez family is a consumer of natural gas for
heating and cooling their home. Panel (a) of Figure 3-5 shows how many BTUs of
natural gas they will buy per year at any given price. The Gonzalez family’s individual demand curve is DGonzalez.
The market demand curve shows how the combined quantity demanded by
all consumers depends on the market price of the good. (Most of the time when
economists refer to the demand curve they mean the market demand curve.) The
market demand curve is the horizontal sum of the individual demand curves of
all consumers in that market. To see what we mean by the term horizontal sum,
assume for a moment that there are only two consumers of natural gas, the
Gonzalez family and the Murray family. The Murray family consumes natural
gas to fuel their natural gas–powered car. The Murray family’s individual demand
curve, DMurray, is shown in panel (b). Panel (c) shows the market demand curve. At
any given price, the quantity demanded by the market is the sum of the quantities
demanded by the Gonzalez family and the Murray family. For example, at a price
of $5 per BTU, the Gonzalez family demands 30 BTUs of natural gas per year and
the Murray family demands 20 BTUs per year. So the quantity demanded by the
market is 50 BTUs per year, as seen on the market demand curve, DMarket.
Clearly, the quantity demanded by the market at any given price is larger with
the Murray family present than it would be if the Gonzalez family were the only
consumer. The quantity demanded at any given price would be even larger if we
added a third consumer, then a fourth, and so on. So an increase in the number
of consumers leads to an increase in demand.
For a review of the factors that shift demand, see Table 3-1.
Individual Demand Curves and the Market Demand Curve
(a) The Gonzalez Family’s
Individual Demand Curve
(b) The Murray Family’s
Individual Demand Curve
(c) Market Demand Curve
Price of
natural
gas
(per BTU)
Price of
natural
gas
(per BTU)
Price of
natural
gas
(per BTU)
$5
$5
$5
DGonzalez
0
30
Quantity of natural gas
(BTUs)
DMarket
DMurray
0
The Gonzalez family and the Murray family are the only
two consumers of natural gas in the market. Panel (a)
shows the Gonzalez family’s individual demand curve: the
number of BTUs they will buy per year at any given price.
Panel (b) shows the Murray family’s individual demand
curve. Given that the Gonzalez family and the Murray
family are the only two consumers, the market demand
20
Quantity of natural gas
(BTUs)
0
50
Quantity of natural gas
(BTUs)
curve, which shows the quantity of BTUs demanded by all
consumers at any given price, is shown in panel (c). The
market demand curve is the horizontal sum of the individual
demand curves of all consumers. In this case, at any given
price, the quantity demanded by the market is the sum of
the quantities demanded by the Gonzalez family and the
Murray family.
CHAPTER 3
TABLE 3-1
Factors That Shift Demand
When this
happens . . .
. . . demand increases
But when this
happens . . .
Price
When the price
of a substitute
rises . . .
S U P P LY A N D D E M A N D
. . . demand decreases
Price
D1
D2
. . . demand for
the original good
increases.
. . . demand for
the original good
decreases.
When the price
of a substitute
falls . . .
D2
Quantity
Price
D1
D2
. . . demand for
the original good
increases.
When the price
of a complement
rises . . .
D2
Quantity
Price
When income
rises . . .
D1
D2
. . . demand for
a normal good
increases.
When income
falls . . .
D2
Price
Price
When income
falls . . .
D1
D2
. . . demand for
an inferior good
increases.
When income
rises . . .
D2
D1
. . . demand for
an inferior good
decreases.
Quantity
Quantity
Price
Price
. . . demand for
the good increases.
D1
D2
When tastes
change against
a good . . .
. . . demand for
the good decreases.
D2
Quantity
D1
Quantity
Price
Price
D1
D2
. . . demand for
the good increases
today.
When the price
is expected to
fall in the
future . . .
D2
Quantity
D1
. . . demand for
the good decreases
today.
Quantity
Price
Price
When the
number of
consumers rises . . .
D1
. . . demand for
a normal good
decreases.
Quantity
Quantity
When the price
is expected to
rise in the
future . . .
D1
. . . demand for
the original good
decreases.
Quantity
Price
When tastes
change in favor
of a good . . .
D1
Quantity
Price
When the price
of a complement
falls . . .
77
D1
D2
Quantity
. . . market
demand for the
good increases.
When the
number of
consumers falls . . .
D2
D1
Quantity
. . . market
demand for the
good decreases.
PA R T 2
S U P P LY A N D D E M A N D
in Action
RLD VIE
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78
Beating the Traffic
Global Warming Images/Alamy
A
Cities can reduce traffic congestion
by raising the price of driving.
Quick Review
• The supply and demand
model is a model of a competitive
market—one in which there are
many buyers and sellers of the
same good or service.
• The demand schedule shows
how the quantity demanded
changes as the price changes. A
demand curve illustrates this
relationship.
• The law of demand asserts
that a higher price reduces the
quantity demanded. Thus, demand
curves normally slope downward.
• An increase in demand leads to
a rightward shift of the demand
curve: the quantity demanded rises
for any given price. A decrease in
demand leads to a leftward shift:
the quantity demanded falls for
any given price. A change in price
results in a change in the quantity
demanded and a movement along
the demand curve.
• The five main factors that
can shift the demand curve are
changes in (1) the price of a related
good, such as a substitute or
a complement, (2) income, (3)
tastes, (4) expectations, and (5) the
number of consumers.
• The market demand curve is the
horizontal sum of the individual
demand curves of all consumers
in the market.
ll big cities have traffic problems, and many local authorities try to discourage driving in the crowded city center. If we think of an auto trip to
the city center as a good that people consume, we can use the economics
of demand to analyze anti-traffic policies.
One common strategy is to reduce the demand for auto trips by lowering the
prices of substitutes. Many metropolitan areas subsidize bus and rail service,
hoping to lure commuters out of their cars. An alternative is to raise the price of
complements: several major U.S. cities impose high taxes on commercial parking
garages and impose short time limits on parking meters, both to raise revenue
and to discourage people from driving into the city.
A few major cities—including Singapore, London, Oslo, Stockholm, and
Milan—have been willing to adopt a direct and politically controversial approach:
reducing congestion by raising the price of driving. Under “congestion pricing”
(or “congestion charging” in the United Kingdom), a charge is imposed on cars
entering the city center during business hours. Drivers buy passes, which are then
debited electronically as they drive by monitoring stations. Compliance is monitored with automatic cameras that photograph license plates.
In 2012, Moscow adopted a modest charge for parking in certain areas in an
attempt to reduce its traffic jams, considered the worst of all major cities. After
the approximately $1.60 charge was applied, city officials estimated that Moscow
traffic decreased by 4%.
The current daily cost of driving in London ranges from £9 to £12 (about $14
to $19). And drivers who don’t pay and are caught pay a fine of £120 (about $192)
for each transgression.
Not surprisingly, studies have shown that after the implementation of congestion pricing, traffic does indeed decrease. In the 1990s, London had some of the
worst traffic in Europe. The introduction of its congestion charge in 2003 immediately reduced traffic in the city center by about 15%, with overall traffic falling
by 21% between 2002 and 2006. And there has been increased use of substitutes,
such as public transportation, bicycles, motorbikes, and ride-sharing. From 2001
to 2011, bike trips in London increased by 79%, and bus usage was up by 30%.
In the United States, the U.S. Department of Transportation has implemented
pilot programs to study congestion pricing. For example, in 2012 Los Angeles
County imposed a congestion charge on an 11-mile stretch of highway in central
Los Angeles. Drivers pay up to $1.40 per mile, the amount depending upon traffic
congestion, with a money-back guarantee that their average speed will never drop
below 45 miles per hour. While some drivers were understandably annoyed at the
charge, others were more philosophical. One driver felt that the toll was a fair price
to escape what often turned into a crawling 45-minute drive, saying, “It’s worth it if
you’re in a hurry to get home. You got to pay the price. If not, get stuck in traffic.”
Check Your Understanding
3-1
1. Explain whether each of the following events represents (i) a shift of the demand
curve or (ii) a movement along the demand curve.
a. A store owner finds that customers are willing to pay more for umbrellas on
rainy days.
b. When Circus Cruise Lines offered reduced prices for summer cruises in the
Caribbean, their number of bookings increased sharply.
c. People buy more long-stem roses the week of Valentine’s Day, even though the
prices are higher than at other times during the year.
d. A sharp rise in the price of gasoline leads many commuters to join carpools in
order to reduce their gasoline purchases.
Solutions appear at back of book.
CHAPTER 3
The Supply Curve
Some deposits of natural gas are easier to tap than others. Before the widespread
use of fracking, drillers would limit their natural gas wells to deposits that lay
in easily reached pools beneath the earth. How much natural gas they would
tap from existing wells, and how extensively they searched for new deposits and
drilled new wells, depended on the price they expected to get for the natural gas.
The higher the price they expected, the more they would tap existing wells as well
as drill and tap new wells.
So just as the quantity of natural gas that consumers want to buy depends
upon the price they have to pay, the quantity that producers of natural gas, or of
any good or service, are willing to produce and sell—the quantity supplied—
depends upon the price they are offered.
S U P P LY A N D D E M A N D
The quantity supplied is the actual
amount of a good or service people
are willing to sell at some specific
price.
A supply schedule shows how
much of a good or service would be
supplied at different prices.
A supply curve shows the
relationship between quantity
supplied and price.
The Supply Schedule and the Supply Curve
The table in Figure 3-6 shows how the quantity of natural gas made available varies
with the price—that is, it shows a hypothetical supply schedule for natural gas.
A supply schedule works the same way as the demand schedule shown in
Figure 3-1: in this case, the table shows the number of BTUs of natural gas producers
are willing to sell at different prices. At a price of $2.50 per BTU, producers are willing to sell only 8 trillion BTUs of natural gas per year. At $2.75 per BTU, they’re willing to sell 9.1 trillion BTUs. At $3, they’re willing to sell 10 trillion BTUs, and so on.
In the same way that a demand schedule can be represented graphically by a
demand curve, a supply schedule can be represented by a supply curve, as shown
in Figure 3-6. Each point on the curve represents an entry from the table.
FIGURE 3-6
The Supply Schedule and the Supply Curve
Price of
natural gas
(per BTU)
Supply Schedule for Natural Gas
Price of
natural gas
(per BTU)
Quantity of
natural gas
supplied
(trillions of BTUs)
$4.00
11.6
3.75
11.5
3.50
11.2
3.25
3.25
10.7
3.00
3.00
10.0
2.75
2.75
9.1
2.50
2.50
8.0
Supply
curve, S
$4.00
3.75
3.50
0
As price rises,
the quantity
supplied rises.
7
9
11
13
15
17
Quantity of natural gas
(trillions of BTUs)
The supply schedule for natural gas is plotted to yield
the corresponding supply curve, which shows how much
of a good producers are willing to sell at any given price.
79
The supply curve and the supply schedule reflect the
fact that supply curves are usually upward sloping: the
quantity supplied rises when the price rises.
80
PA R T 2
S U P P LY A N D D E M A N D
A shift of the supply curve is a
change in the quantity supplied of a
good or service at any given price.
It is represented by the change of
the original supply curve to a new
position, denoted by a new supply
curve.
A movement along the supply
curve is a change in the quantity
supplied of a good arising from a
change in the good’s price.
Shifts of the Supply Curve
As we described in the opening story, innovations in the technology of drilling natural
gas deposits have recently led to a huge increase in U.S. production of natural gas—a
30% increase in daily production from 2005 through 2014. Figure 3-7 illustrates these
events in terms of the supply schedule and the supply curve for natural gas. The table
in Figure 3-7 shows two supply schedules. The schedule before improved natural
gas–drilling technology was adopted is the same one as in Figure 3-6. The second
schedule shows the supply of natural gas after the improved technology was adopted.
Just as a change in demand schedules leads to a shift of the demand curve, a change
in supply schedules leads to a shift of the supply curve—a change in the quantity
supplied at any given price. This is shown in Figure 3-7 by the shift of the supply curve
before the adoption of new natural gas–drilling technology, S1, to its new position after
the adoption of new natural gas–drilling technology, S2. Notice that S2 lies to the right
of S1, a reflection of the fact that quantity supplied rises at any given price.
As in the analysis of demand, it’s crucial to draw a distinction between such
shifts of the supply curve and movements along the supply curve—changes in
the quantity supplied arising from a change in price. We can see this difference in
Figure 3-8. The movement from point A to point B is a movement along the supply curve: the quantity supplied rises along S1 due to a rise in price. Here, a rise
in price from $3 to $3.50 leads to a rise in the quantity supplied from 10 trillion
to 11.2 trillion BTUs of natural gas. But the quantity supplied can also rise when
An Increase in Supply
FIGURE 3-7
Price of
natural gas
(per BTU)
Supply Schedules for Natural Gas
S1
$4.00
3.75
3.50
Suppose that the price of natural gas rises from $3 to $3.25; we can see that
the quantity of natural gas producers are willing to sell rises from 10 trillion to
10.7 trillion BTUs. This is the normal situation for a supply curve, that a higher
price leads to a higher quantity supplied. So just as demand curves normally
slope downward, supply curves normally slope upward: the higher the price being
offered, the more of any good or service producers will be willing to sell.
S2
Price of
natural gas
(per BTU)
Supply curve
before new
technology
3.25
3.00
Supply curve
after new
technology
2.75
2.50
0
7
9
$4.00
3.75
3.50
3.25
3.00
2.75
2.50
Quantity of natural gas supplied
(trillions of BTUs)
Before new
technology
After new
technology
11.6
11.5
11.2
10.7
10.0
9.1
8.0
13.9
13.8
13.4
12.8
12.0
10.9
9.6
11
13
15
17
Quantity of natural gas
(trillions of BTUs)
The adoption of improved natural gas–drilling technology
generated an increase in supply—a rise in the quantity
supplied at any given price. This event is represented by the
two supply schedules—one showing supply before the new
technology was adopted, the other showing supply after
the new technology was adopted—and their corresponding
supply curves. The increase in supply shifts the supply curve
to the right.
CHAPTER 3
FIGURE 3-8
S U P P LY A N D D E M A N D
Movement Along the Supply Curve versus Shift of the Supply Curve
The increase in quantity supplied
when going from point A to point B
reflects a movement along the supply
curve: it is the result of a rise in the
price of the good. The increase in
quantity supplied when going from
point A to point C reflects a shift of
the supply curve: it is the result of an
increase in the quantity supplied at
any given price.
Price of
natural gas
(per BTU)
$4.00
3.75
S2
S1
A movement
along the supply
curve . . .
3.50
B
3.25
A
3.00
C
. . . is not the
same thing as
a shift of the
supply curve.
2.75
2.50
0
7
10 11.2 12
15
17
Quantity of natural gas
(trillions of BTUs)
the price is unchanged if there is an increase in supply—a rightward shift of the
supply curve. This is shown by the rightward shift of the supply curve from S1 to
S2. Holding the price constant at $3, the quantity supplied rises from 10 trillion
BTUs at point A on S1 to 12 billion pounds at point C on S2.
Understanding Shifts of the Supply Curve
Figure 3-9 illustrates the two basic ways in which supply curves can shift. When
economists talk about an “increase in supply,” they mean a rightward shift of the
supply curve: at any given price, producers supply a larger quantity of the good than
before. This is shown in Figure 3-9 by the rightward shift of the original supply
curve S1 to S2. And when economists talk about a “decrease in supply,” they mean
FIGURE 3-9
Shifts of the Supply Curve
Any event that increases supply
shifts the supply curve to the right,
reflecting a rise in the quantity
supplied at any given price. Any
event that decreases supply shifts
the supply curve to the left, reflecting
a fall in the quantity supplied at any
given price.
Price
S3
S1
S2
Increase
in supply
Decrease
in supply
Quantity
81
82
PA R T 2
S U P P LY A N D D E M A N D
An input is a good or service that
is used to produce another good or
service.
a leftward shift of the supply curve: at any given price, producers supply a smaller
quantity of the good than before. This is represented by the leftward shift of S1 to S3.
Economists believe that shifts of the supply curve for a good or service are mainly
the result of five factors (though, as with demand, there are other possible causes):
• Changes in input prices
• Changes in the prices of related goods or services
• Changes in technology
• Changes in expectations
• Changes in the number of producers
Changes in Input Prices To produce output, you need inputs. For example,
to make vanilla ice cream, you need vanilla beans, cream, sugar, and so on. An
input is any good or service that is used to produce another good or service.
Inputs, like outputs, have prices. And an increase in the price of an input makes
the production of the final good more costly for those who produce and sell it. So
producers are less willing to supply the final good at any given price, and the supply curve shifts to the left. That is, supply decreases. For example, fuel is a major
cost for airlines. When oil prices surged in 2007–2008, airlines began cutting back
on their flight schedules and some went out of business.
Similarly, a fall in the price of an input makes the production of the final good
less costly for sellers. They are more willing to supply the good at any given price,
and the supply curve shifts to the right. That is, supply increases.
Changes in the Prices of Related Goods or Services A single producer
often produces a mix of goods rather than a single product. For example, an oil
refinery produces gasoline from crude oil, but it also produces heating oil and
other products from the same raw material. When a producer sells several products, the quantity of any one good it is willing to supply at any given price depends
on the prices of its other co-produced goods.
This effect can run in either direction. An oil refiner will supply less gasoline
at any given price when the price of heating oil rises, shifting the supply curve
for gasoline to the left. But it will supply more gasoline at any given price when
the price of heating oil falls, shifting the supply curve for gasoline to the right.
This means that gasoline and other co-produced oil products are substitutes in
production for refiners.
In contrast, due to the nature of the production process, other goods can be complements in production. For example, producers of natural gas often find that natural
gas wells also produce oil as a by-product of extraction. The higher the price at which
a driller can sell its oil, the more willing it will be to drill natural gas wells and the
more natural gas it will supply at any given price. In other words, higher oil prices
lead to more natural gas supplied at any given price because oil and natural gas can
be tapped simultaneously. As a result, oil is a complement in the production of natural gas. The reverse is also true: natural gas is a complement in the production of oil.
Changes in Technology As the opening story illustrates, changes in technology
affect the supply curve. Improvements in technology enable producers to spend less on
inputs (in this case, drilling equipment, labor, land purchases, and so on), yet still produce the same amount of output. When a better technology becomes available, reducing the cost of production, supply increases and the supply curve shifts to the right.
Improved technology enabled natural gas producers to more than double output in less than two years. Technology is also the main reason that natural gas
has remained relatively cheap, even as demand has grown.
Changes in Expectations Just as changes in expectations can shift the
demand curve, they can also shift the supply curve. When suppliers have some
choice about when they put their good up for sale, changes in the expected future
price of the good can lead a supplier to supply less or more of the good today.
CHAPTER 3
For example, consider the fact that gasoline and other oil products are often
stored for significant periods of time at oil refineries before being sold to consumers.
In fact, storage is normally part of producers’ business strategy. Knowing that the
demand for gasoline peaks in the summer, oil refiners normally store some of their
gasoline produced during the spring for summer sale. Similarly, knowing that the
demand for heating oil peaks in the winter, they normally store some of their heating
oil produced during the fall for winter sale.
In each case, there’s a decision to be made between selling the product now
versus storing it for later sale. Which choice a producer makes depends on a
comparison of the current price versus the expected future price. This example
illustrates how changes in expectations can alter supply: an increase in the anticipated future price of a good or service reduces supply today, a leftward shift of
the supply curve. But a fall in the anticipated future price increases supply today,
a rightward shift of the supply curve.
S U P P LY A N D D E M A N D
An individual supply curve
illustrates the relationship between
quantity supplied and price for an
individual producer.
Changes in the Number of Producers Just as changes in the number of consumers affect the demand curve, changes in the number of producers affect the
supply curve. Let’s examine the individual supply curve, by looking at panel (a)
in Figure 3-10. The individual supply curve shows the relationship between quantity supplied and price for an individual producer. For example, suppose that
Louisiana Drillers is a natural gas producer and that panel (a) of Figure 3-10
shows the quantity of BTUs it will supply per year at any given price. Then
SLouisiana is its individual supply curve.
The market supply curve shows how the combined total quantity supplied by all
individual producers in the market depends on the market price of that good. Just as
the market demand curve is the horizontal sum of the individual demand curves of
all consumers, the market supply curve is the horizontal sum of the individual supply curves of all producers. Assume for a moment that there are only two natural gas
producers, Louisiana Drillers and Allegheny Natural Gas. Allegheny’s individual supply curve is shown in panel (b). Panel (c) shows the market supply curve. At any given
price, the quantity supplied to the market is the sum of the quantities supplied by
FIGURE 3-10
The Individual Supply Curve and the Market Supply Curve
(a) Louisiana Drillers’
Individual Supply Curve
Price of
natural gas
(per BTU)
$2
SLouisiana
(b) Allegheny Natural Gas’s
Individual Supply Curve
Price of
natural gas
(per BTU)
$2
SAllegheny
(c) Market Supply Curve
Price of
natural gas
(per BTU)
1
1
0
0
0
1
2
Quantity of natural gas
(hundreds of thousands of BTUs)
Panel (a) shows the individual supply curve for Louisiana
Drillers, SLouisiana, the quantity it will sell at any given price.
Panel (b) shows the individual supply curve for Allegheny
Natural Gas, SAllegheny. The market supply curve, which shows
SMarket
$2
1
1
2
3
Quantity of natural gas
(hundreds of thousands of BTUs)
83
1
2
3
4
5
Quantity of natural gas
(hundreds of thousands of BTUs)
the quantity of natural gas supplied by all producers at any
given price is shown in panel (c). The market supply curve
is the horizontal sum of the individual supply curves of all
producers.
84
PA R T 2
S U P P LY A N D D E M A N D
Louisiana Drillers and Allegheny Natural Gas. For example at a price of around $2 per
BTU, Louisiana Drillers supplies 200,000 BTUs and Allegheny Natural Gas supplies
100,000 BTUs per year, making the quantity supplied to the market 300,000 BTUs.
Clearly, the quantity supplied to the market at any given price is larger when
Allegheny Natural Gas is also a producer than it would be if Louisiana Drillers were
the only supplier. The quantity supplied at a given price would be even larger if we
added a third producer, then a fourth, and so on. So an increase in the number of
producers leads to an increase in supply and a rightward shift of the supply curve.
For a review of the factors that shift supply, see Table 3-2.
Factors That Shift Supply
TABLE 3-2
When this
happens . . .
. . . supply increases
But when this
happens . . .
Price
When the price
of an input
falls . . .
. . . supply decreases
Price
S1
. . . supply
of the good
increases.
S2
When the price
of an input
rises . . .
S2
S1
Quantity
Quantity
Price
When the price
of a substitute in
production falls . . .
Price
S1
. . . supply
of the original
good increases.
S2
When the price
of a substitute in
production rises . . .
S2
Quantity
Price
Price
S1
. . . supply
of the original
good increases.
S2
When the price of
a complement in
production falls . . .
S2
Quantity
Price
Price
S1
. . . supply
of the good
increases.
S2
When the best
technology used
to produce the
good is no longer
available . . .
S2
Quantity
Price
Price
S1
. . . supply
of the good
increases today.
S2
When the price is
expected to rise
in the future . . .
S2
. . . supply
of the good
decreases today.
S1
Quantity
Quantity
Price
When the number
of producers
rises . . .
. . . supply
of the good
decreases.
S1
Quantity
When the price is
expected to fall
in the future . . .
. . . supply
of the original
good decreases.
S1
Quantity
When the technology
used to produce the
good improves . . .
. . . supply
of the original
good decreases.
S1
Quantity
When the price of
a complement in
production rises . . .
. . . supply
of the good
decreases.
Price
S1
. . . market
supply of the
good increases.
S2
Quantity
When the number
of producers
falls . . .
S2
. . . market
supply of the
good decreases.
S1
Quantity
in Action
S U P P LY A N D D E M A N D
85
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CHAPTER 3
Only Creatures Small and Pampered
B
iStockphoto/Thinkstock
ack in the 1970s, British television featured a popular show titled All Creatures
Great and Small. It chronicled the real life of James Herriot, a country veterinarian who tended to cows, pigs, sheep, horses, and the
occasional house pet, often under arduous conditions, in rural
England during the 1930s. The show made it clear that in those
days the local vet was a critical member of farming communities,
saving valuable farm animals and helping farmers survive financially. And it was also clear that Mr. Herriot considered his life’s
work well spent.
But that was then and this is now. According to an article
in the New York Times, the United States has experienced a
severe decline in the number of farm veterinarians over the
past 25 years. The source of the problem is competition. As
the number of household pets has increased and the incomes
of pet owners have grown, the demand for pet veterinarians
has increased sharply. As a result, vets are being drawn away
from the business of caring for farm animals into the more
lucrative business of caring for pets. As one vet stated, she
began her career caring for farm animals but changed her
mind after “doing a C-section on a cow and it’s 50 bucks. Do
a C-section on a Chihuahua and you get $300. It’s the money. Higher spending on pets means fewer veterinarians are available
I hate to say that.”
to tend to farm animals.
How can we translate this into supply and demand curves?
Farm veterinary services and pet veterinary services are like gasoline and fuel oil:
they’re related goods that are substitutes in production. A veterinarian typically speQuick Review
cializes in one type of practice or the other, and that decision often depends on the
• The supply schedule shows
going price for the service. America’s growing pet population, combined with the
how the quantity supplied
increased willingness of doting owners to spend on their companions’ care, has driven
depends on the price. The supply
up the price of pet veterinary services. As a result, fewer and fewer veterinarians have
curve illustrates this relationship.
gone into farm animal practice. So the supply curve of farm veterinarians has shifted
• Supply curves are normally
leftward—fewer farm veterinarians are offering their services at any given price.
upward sloping: at a higher price,
In the end, farmers understand that it is all a matter of dollars and cents; they get
producers are willing to supply
fewer veterinarians because they are unwilling to pay more. As one farmer, who had
more of a good or service.
recently lost an expensive cow due to the unavailability of a veterinarian, stated, “The
• A change in price results in a
fact that there’s nothing you can do, you accept it as a business expense now. You
movement along the supply
curve and a change in the
didn’t used to. If you have livestock, sooner or later you’re going to have deadstock.”
quantity supplied.
(Although we should note that this farmer could have chosen to pay more for a vet
who would have then saved his cow.)
• Increases or decreases in supply
Check Your Understanding
3-2
1. Explain whether each of the following events represents (i) a shift of the supply
curve or (ii) a movement along the supply curve.
a. More homeowners put their houses up for sale during a real estate boom that
causes house prices to rise.
b. Many strawberry farmers open temporary roadside stands during harvest season, even though prices are usually low at that time.
c. Immediately after the school year begins, fast-food chains must raise wages,
which represent the price of labor, to attract workers.
d. Many construction workers temporarily move to areas that have suffered hurricane damage, lured by higher wages.
e. Since new technologies have made it possible to build larger cruise ships (which
are cheaper to run per passenger), Caribbean cruise lines offer more cabins, at
lower prices, than before.
Solutions appear at back of book.
lead to shifts of the supply
curve. An increase in supply is
a rightward shift: the quantity
supplied rises for any given price.
A decrease in supply is a leftward
shift: the quantity supplied falls for
any given price.
• The five main factors that can
shift the supply curve are changes in
(1) input prices, (2) prices of related
goods or services, (3) technology,
(4) expectations, and (5) number of
producers.
• The market supply curve is the
horizontal sum of the individual
supply curves of all producers in
the market.
86
PA R T 2
S U P P LY A N D D E M A N D
A competitive market is in equilibrium
when price has moved to a level
at which the quantity of a good
or service demanded equals the
quantity of that good or service
supplied. The price at which this
takes place is the equilibrium
price, also referred to as the
market-clearing price. The
quantity of the good or service
bought and sold at that price is the
equilibrium quantity.
Supply, Demand, and Equilibrium
We have now covered the first three key elements in the supply and demand
model: the demand curve, the supply curve, and the set of factors that shift
each curve. The next step is to put these elements together to show how they
can be used to predict the actual price at which the good is bought and sold,
as well as the actual quantity transacted.
What determines the price at which a good or service is bought and sold?
What determines the quantity transacted of the good or service? In Chapter 1
we learned the general principle that markets move toward equilibrium, a situation in which no individual would be better off taking a different action. In the
case of a competitive market, we can be more specific: a competitive market is in
equilibrium when the price has moved to a level at which the quantity of a good
demanded equals the quantity of that good supplied. At that price, no individual
seller could make herself better off by offering to sell either more or less of the
good and no individual buyer could make himself better off by offering to buy
more or less of the good. In other words, at the market equilibrium, price has
moved to a level that exactly matches the quantity demanded by consumers to the
quantity supplied by sellers.
The price that matches the quantity supplied and the quantity demanded is
the equilibrium price; the quantity bought and sold at that price is the equilibrium quantity. The equilibrium price is also known as the market-clearing
price: it is the price that “clears the market” by ensuring that every buyer willing
to pay that price finds a seller willing to sell at that price, and vice versa. So how
do we find the equilibrium price and quantity?
Finding the Equilibrium Price and Quantity
The easiest way to determine the equilibrium price and quantity in a market is
by putting the supply curve and the demand curve on the same diagram. Since
the supply curve shows the quantity supplied at any given price and the demand
curve shows the quantity demanded at any given price, the price at which the two
curves cross is the equilibrium price: the price at which quantity supplied equals
quantity demanded.
Figure 3-11 combines the demand curve from Figure 3-1 and the supply curve
from Figure 3-6. They intersect at point E, which is the equilibrium of this market;
$3 is the equilibrium price and 10 trillion BTUs is the equilibrium quantity.
Let’s confirm that point E fits our definition of equilibrium. At a price of $3
per BTU, natural gas producers are willing to sell 10 trillion BTUs a year and
natural gas consumers want to buy 10 trillion BTUs a year. So at the price of
$3 per BTU, the quantity of natural gas supplied equals the quantity demanded.
Notice that at any other price the market would not clear: every willing buyer
P I T FA L L S
BOUGHT AND SOLD?
We have been talking about the price at
which a good or service is bought and sold,
as if the two were the same. But shouldn’t
we make a distinction between the price
received by sellers and the price paid by
buyers? In principle, yes; but it is helpful at
this point to sacrifice a bit of realism in the
interest of simplicity—by assuming away
the difference between the prices received
by sellers and those paid by buyers.
In reality, there is often a middleman—
someone who brings buyers and sellers together. The middleman buys from
suppliers, then sells to consumers at a
markup. For example, natural gas brokers buy natural gas from drillers, and
then sell the natural gas to gas companies who distribute it to households
and firms. The drillers generally receive
less than the gas companies pay per
BTU of gas. But no mystery there: that
difference is how natural gas brokers
make a living.
In many markets, however, the difference between the buying and selling
price is quite small. So it’s not a bad
approximation to think of the price paid
by buyers as being the same as the price
received by sellers. And that is what we
assume in this chapter.
CHAPTER 3
FIGURE 3-11
S U P P LY A N D D E M A N D
87
Market Equilibrium
Market equilibrium occurs at point
E, where the supply curve and
the demand curve intersect. In
equilibrium, the quantity demanded is
equal to the quantity supplied. In this
market, the equilibrium price is $3
per BTU and the equilibrium quantity
is 10 trillion BTUs per year.
Price of
natural gas
(per BTU)
Supply
$4.00
3.75
3.50
3.25
Equilibrium
price
E
3.00
Equilibrium
2.75
2.50
0
Demand
7
10
Equilibrium
quantity
13
15
17
Quantity of natural gas
(trillions of BTUs)
would not be able to find a willing seller, or vice versa. More specifically, if
the price were more than $3, the quantity supplied would exceed the quantity demanded; if the price were less than $3, the quantity demanded would
exceed the quantity supplied.
The model of supply and demand, then, predicts that given the demand and
supply curves shown in Figure 3-11, 10 trillion BTUs would change hands at a
price of $3 per BTU. But how can we be sure that the market will arrive at the
equilibrium price? We begin by answering three simple questions:
1. Why do all sales and purchases in a market take place at the same price?
2. Why does the market price fall if it is above the equilibrium price?
Why Do All Sales and Purchases in a Market Take
Place at the Same Price?
There are some markets where the same good can sell for many different prices,
depending on who is selling or who is buying. For example, have you ever bought
a souvenir in a “tourist trap” and then seen the same item on sale somewhere else
(perhaps even in the shop next door) for a lower price? Because tourists don’t know
which shops offer the best deals and don’t have time for comparison shopping, sellers in tourist areas can charge different prices for the same good.
But in any market where the buyers and sellers have both been around for
some time, sales and purchases tend to converge at a generally uniform price, so
we can safely talk about the market price. It’s easy to see why. Suppose a seller
offered a potential buyer a price noticeably above what the buyer knew other
people to be paying. The buyer would clearly be better off shopping elsewhere—
unless the seller were prepared to offer a better deal.
Conversely, a seller would not be willing to sell for significantly less than the
amount he knew most buyers were paying; he would be better off waiting to get a
©Dan Piraro
3. Why does the market price rise if it is below the equilibrium price?
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FIGURE 3-12
Price Above Its Equilibrium Level Creates a Surplus
The market price of $3.50 is above
the equilibrium price of $3. This
creates a surplus: at a price of
$3.50, producers would like to sell
11.2 trillion BTUs but consumers
want to buy only 8.1 trillion BTUs, so
there is a surplus of 3.1 trillion BTUs.
This surplus will push the price down
until it reaches the equilibrium price
of $3.
Price of
natural gas
(per BTU)
Supply
$4.00
3.75
Surplus
3.50
3.25
E
3.00
2.75
2.50
0
Demand
7
8.1
Quantity
demanded
10
11.2
Quantity
supplied
13
15
17
Quantity of natural gas
(trillions of BTUs)
more reasonable customer. So in any well-established, ongoing market, all sellers
receive and all buyers pay approximately the same price. This is what we call the
market price.
Why Does the Market Price Fall If It Is Above the
Equilibrium Price?
Suppose the supply and demand curves are as shown in Figure 3-11 but the
market price is above the equilibrium level of $3—say, $3.50. This situation is
illustrated in Figure 3-12. Why can’t the price stay there?
As the figure shows, at a price of $3.50 there would be more BTUs of natural
gas available than consumers wanted to buy: 11.2 trillion BTUs versus 8.1 trillion BTUs. The difference of 3.1 trillion BTUs is the surplus—also known as the
excess supply—of natural gas at $3.50.
This surplus means that some natural gas producers are frustrated: at the current price, they cannot find consumers who want to buy their natural gas. The surplus offers an incentive for those frustrated would-be sellers to offer a lower price
in order to poach business from other producers and entice more consumers to
buy. The result of this price cutting will be to push the prevailing price down until
it reaches the equilibrium price. So the price of a good will fall whenever there is
a surplus—that is, whenever the market price is above its equilibrium level.
There is a surplus of a good or
service when the quantity supplied
exceeds the quantity demanded.
Surpluses occur when the price is
above its equilibrium level.
There is a shortage of a good or
service when the quantity demanded
exceeds the quantity supplied.
Shortages occur when the price is
below its equilibrium level.
Why Does the Market Price Rise If It Is Below the
Equilibrium Price?
Now suppose the price is below its equilibrium level—say, at $2.75 per BTU, as
shown in Figure 3-13. In this case, the quantity demanded, 11.5 trillion BTUs,
exceeds the quantity supplied, 9.1 trillion BTUs, implying that there are would-be
buyers who cannot find natural gas: there is a shortage, also known as an excess
demand, of 2.4 trillion BTUs.
CHAPTER 3
FIGURE 3-13
S U P P LY A N D D E M A N D
Price Below Its Equilibrium Level Creates a Shortage
The market price of $2.75 is below
the equilibrium price of $3. This
creates a shortage: consumers want
to buy 11.5 trillion BTUs, but only
9.1 trillion BTUs are for sale, so there
is a shortage of 2.4 trillion BTUs.
This shortage will push the price up
until it reaches the equilibrium price
of $3.
Price of
natural gas
(per BTU)
Supply
$4.00
3.75
3.50
3.25
E
3.00
2.75
Shortage
2.50
0
7
9.1 10
Quantity
supplied
11.5
Quantity
demanded
Demand
13
15
17
Quantity of natural gas
(trillions of BTUs)
When there is a shortage, there are frustrated would-be buyers—people
who want to purchase natural gas but cannot find willing sellers at the current price. In this situation, either buyers will offer more than the prevailing
price or sellers will realize that they can charge higher prices. Either way, the
result is to drive up the prevailing price. This bidding up of prices happens
whenever there are shortages—and there will be shortages whenever the price
is below its equilibrium level. So the market price will always rise if it is below
the equilibrium level.
Using Equilibrium to Describe Markets
We have now seen that a market tends to have a single price, the equilibrium
price. If the market price is above the equilibrium level, the ensuing surplus
leads buyers and sellers to take actions that lower the price. And if the market price is below the equilibrium level, the ensuing shortage leads buyers
and sellers to take actions that raise the price. So the market price always
moves toward the equilibrium price, the price at which there is neither surplus nor shortage.
s
ECONOMICS
in Action
The Price of Admission
T
he market equilibrium, so the theory goes, is pretty egalitarian because
the equilibrium price applies to everyone. That is, all buyers pay the same
price—the equilibrium price—and all sellers receive that same price. But
is this realistic?
The market for concert tickets is an example that seems to contradict the theory—
there’s one price at the box office, and there’s another price (typically much higher)
for the same event online where people who already have tickets resell them, such as
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Frazer Harrision/Getty Images
StubHub.com or eBay. For example, compare the box office price
for a Drake concert in Miami, Florida, to the StubHub.com price for
seats in the same location: $88.50 versus $155.
Puzzling as this may seem, there is no contradiction once we
take opportunity costs and tastes into account. For major events,
buying tickets from the box office means waiting in very long
lines. Ticket buyers who use online resellers have decided that the
opportunity cost of their time is too high to spend waiting in line.
And tickets for major events being sold at face value by online box
offices often sell out within minutes. In this case, some people
who want to go to the concert badly but have missed out on the
opportunity to buy cheaper tickets from the online box office are
willing to pay the higher online reseller price.
Not only that—at StubHub.com, you can see that markets
The competitive market model determines the price you
really do move to equilibrium. You’ll notice that the prices quoted
pay for concert tickets.
by different sellers for seats close to one another are also very
close: $184.99 versus $185 for seats on the main floor of the Drake concert. As the
competitive market model predicts, units of the same good end up selling for the
same price. And prices move in response to demand and supply.
According to an article in the New York Times, tickets on StubHub.com can
Quick Review
sell for less than the face value for events with little appeal, but prices can sky• Price in a competitive market
rocket for events that are in high demand. (The article quotes a price of $3,530
moves to the equilibrium price,
for a Madonna concert.) Even StubHub.com’s chief executive says his site is “the
or market-clearing price, where
embodiment of supply-and-demand economics.”
the quantity supplied is equal
So the theory of competitive markets isn’t just speculation. If you want to
to the quantity demanded. This
quantity is the equilibrium
experience it for yourself, try buying tickets to a concert.
quantity.
• All sales and purchases in a
market take place at the same
price. If the price is above its
equilibrium level, there is a
surplus that drives the price
down to the equilibrium level. If
the price is below its equilibrium
level, there is a shortage that
drives the price up to the
equilibrium level.
Check Your Understanding
3-3
1. In the following three situations, the market is initially in equilibrium. Explain the
changes in either supply or demand that result from each event. After each event
described below, does a surplus or shortage exist at the original equilibrium price?
What will happen to the equilibrium price as a result?
a. 2013 was a very good year for California wine-grape growers, who produced a
bumper crop.
b. A fter a hurricane, Florida hoteliers often find that many people cancel their
upcoming vacations, leaving them with empty hotel rooms.
c. A fter a heavy snowfall, many people want to buy second-hand snowblowers at
the local tool shop.
Solutions appear at back of book.
Changes in Supply and Demand
The huge fall in the price of natural gas from $14 to $2 per BTU from 2006 to 2013
may have come as a surprise to consumers, but to suppliers it was no surprise
at all. Suppliers knew that advances in drilling technology had opened up vast
reserves of natural gas that had been too costly to tap in the past. And, predictably, an increase in supply reduces the equilibrium price.
The adoption of improved drilling technology is an example of an event that
shifted the supply curve for a good without having an effect on the demand curve.
There are many such events. There are also events that shift the demand curve
without shifting the supply curve. For example, a medical report that chocolate
is good for you increases the demand for chocolate but does not affect the supply.
Events often shift either the supply curve or the demand curve, but not both; it is
therefore useful to ask what happens in each case.
CHAPTER 3
S U P P LY A N D D E M A N D
We have seen that when a curve shifts, the equilibrium price and quantity
change. We will now concentrate on exactly how the shift of a curve alters the
equilibrium price and quantity.
What Happens When the Demand Curve Shifts
Heating oil and natural gas are substitutes: if the price of heating oil rises, the
demand for natural gas will increase, and if the price of heating oil falls, the
demand for natural gas will decrease. But how does the price of heating oil affect
the market equilibrium for natural gas?
Figure 3-14 shows the effect of a rise in the price of heating oil on the market
for natural gas. The rise in the price of heating oil increases the demand for natural gas. Point E1 shows the equilibrium corresponding to the original demand
curve, with P1 the equilibrium price and Q1 the equilibrium quantity bought and
sold.
An increase in demand is indicated by a rightward shift of the demand curve
from D1 to D2. At the original market price P1, this market is no longer in equilibrium: a shortage occurs because the quantity demanded exceeds the quantity supplied. So the price of natural gas rises and generates an increase in the quantity
supplied, an upward movement along the supply curve. A new equilibrium is established at point E2, with a higher equilibrium price, P2, and higher equilibrium
quantity, Q2. This sequence of events reflects a general principle: When demand
for a good or service increases, the equilibrium price and the equilibrium quantity
of the good or service both rise.
What would happen in the reverse case, a fall in the price of heating oil? A
fall in the price of heating oil reduces the demand for natural gas, shifting the
demand curve to the left. At the original price, a surplus occurs as quantity supplied exceeds quantity demanded. The price falls and leads to a decrease in the
quantity supplied, resulting in a lower equilibrium price and a lower equilibrium
quantity. This illustrates another general principle: When demand for a good or
service decreases, the equilibrium price and the equilibrium quantity of the good or
service both fall.
FIGURE 3-14
Equilibrium and Shifts of the Demand Curve
The original equilibrium in the
market for natural gas is at E1, at
the intersection of the supply curve
and the original demand curve, D1.
A rise in the price of heating oil, a
substitute, shifts the demand curve
rightward to D 2. A shortage exists at
the original price, P1, causing both
the price and quantity supplied to
rise, a movement along the supply
curve. A new equilibrium is reached
at E2, with a higher equilibrium price,
P 2, and a higher equilibrium quantity,
Q 2. When demand for a good or
service increases, the equilibrium
price and the equilibrium quantity of
the good or service both rise.
Price of
natural gas
An increase
in demand . . .
Supply
E2
P2
Price
rises
P1
E1
. . . leads to a
movement along
the supply curve to
a higher equilibrium
price and higher
equilibrium quantity.
D1
Q1
Q2
Quantity rises
D2
Quantity of natural gas
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S U P P LY A N D D E M A N D
To summarize how a market responds to a change in demand: An increase in
demand leads to a rise in both the equilibrium price and the equilibrium quantity. A
decrease in demand leads to a fall in both the equilibrium price and the equilibrium
quantity.
What Happens When the Supply Curve Shifts
For most goods and services, it is a bit easier to predict changes in supply than
changes in demand. Physical factors that affect supply, like weather or the availability of inputs, are easier to get a handle on than the fickle tastes that affect
demand. Still, with supply as with demand, what we can best predict are the
effects of shifts of the supply curve.
As we mentioned in the opening story, improved drilling technology significantly increased the supply of natural gas from 2006 onward. Figure 3-15 shows
how this shift affected the market equilibrium. The original equilibrium is at
E1, the point of intersection of the original supply curve, S1, with an equilibrium
price P1 and equilibrium quantity Q1. As a result of the improved technology, supply increases and S1 shifts rightward to S2. At the original price P1, a surplus of
natural gas now exists and the market is no longer in equilibrium. The surplus
causes a fall in price and an increase in the quantity demanded, a downward
movement along the demand curve. The new equilibrium is at E2, with
an equilibrium price P2 and an equilibrium quantity Q2 . In the new equiP I T FA L L S
librium E2, the price is lower and the equilibrium quantity is higher than
WHICH CURVE IS IT, ANYWAY?
before. This can be stated as a general principle: When supply of a good or
When the price of some good or service
service increases, the equilibrium price of the good or service falls and the
changes, in general, we can say that this
equilibrium quantity of the good or service rises.
reflects a change in either supply or demand.
But it is easy to get confused about which
What happens to the market when supply falls? A fall in supply leads
one. A helpful clue is the direction of change
to a leftward shift of the supply curve. At the original price a shortage
in the quantity. If the quantity sold changes in
now exists; as a result, the equilibrium price rises and the quantity
the same direction as the price—for example,
demanded falls. This describes what happened to the market for natural
if both the price and the quantity rise—this
gas after Hurricane Katrina damaged natural gas production in the Gulf
suggests that the demand curve has shifted.
of Mexico in 2006. We can formulate a general principle: When supply of
If the price and the quantity move in opposite
a good or service decreases, the equilibrium price of the good or service rises
directions, the likely cause is a shift of the
supply curve.
and the equilibrium quantity of the good or service falls.
FIGURE 3-15
Equilibrium and Shifts of the Supply Curve
The original equilibrium in the market
is at E1. Improved technology causes
an increase in the supply of natural
gas and shifts the supply curve
rightward from S1 to S2. A new
equilibrium is established at E2, with
a lower equilibrium price, P 2, and a
higher equilibrium quantity, Q 2.
Price of
natural gas
S1
S2
E1
P1
Price
falls
P2
E2
An increase
in supply . . .
. . . leads to a
movement along
the demand curve to
a lower equilibrium
price and higher
equilibrium quantity.
Demand
Q1
Q2
Quantity rises
Quantity of natural gas
CHAPTER 3
S U P P LY A N D D E M A N D
To summarize how a market responds to a change in supply: An increase in supply
leads to a fall in the equilibrium price and a rise in the equilibrium quantity. A decrease
in supply leads to a rise in the equilibrium price and a fall in the equilibrium quantity.
Simultaneous Shifts of Supply and Demand Curves
Finally, it sometimes happens that events shift both the demand and supply curves
at the same time. This is not unusual; in real life, supply curves and demand curves
for many goods and services shift quite often because the economic environment
continually changes. Figure 3-16 illustrates two examples of simultaneous shifts.
In both panels there is an increase in supply—that is, a rightward shift of the supply curve from S1 to S2—representing, for example, adoption of an improved drilling technology. Notice that the rightward shift in panel (a) is larger than the one
in panel (b): we can suppose that panel (a) represents a small, incremental change
in technology while panel (b) represents a big advance in technology. Both panels
show a decrease in demand—that is, a leftward shift from D1 to D2. Also notice
that the leftward shift in panel (a) is relatively larger than the one in panel (b): we
can suppose that panel (a) reflects the effect on demand of a deep recession in the
overall economy, while panel (b) reflects the effect of a mild winter.
In both cases the equilibrium price falls from P1 to P2 as the equilibrium
moves from E1 to E2. But what happens to the equilibrium quantity, the quantity
of natural gas bought and sold? In panel (a) the decrease in demand is large relative to the increase in supply, and the equilibrium quantity falls as a result. In
panel (b) the increase in supply is large relative to the decrease in demand, and
the equilibrium quantity rises as a result. That is, when demand decreases and
supply increases, the actual quantity bought and sold can go either way depending on how much the demand and supply curves have shifted.
FIGURE 3-16
Simultaneous Shifts of the Demand and Supply Curves
(a) One Possible Outcome:
Price Falls, Quantity Falls
Price
of
natural
gas
S1
E1
Price
of
natural
gas
S2
S1
S2
Large
increase
in supply
E1
Small
increase
in supply
P1
P2
(b) Another Possible Outcome:
Price Falls, Quantity Rises
P1
E2
Small
decrease
in demand
E2
P2
D1
D2
Large
decrease
in demand
Q2 Q1
Quantity of natural gas
In panel (a) there is a simultaneous leftward shift of the
demand curve and a rightward shift of the supply curve. Here
the decrease in demand is relatively larger than the increase in
supply, so the equilibrium quantity falls as the equilibrium price
also falls. In panel (b) there is also a simultaneous leftward
D2
Q1
D1
Q2
Quantity of natural gas
shift of the demand curve and rightward shift of the supply
curve. Here the increase in supply is large relative to the
decrease in demand, so the equilibrium quantity rises as the
equilibrium price falls.
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S U P P LY A N D D E M A N D
Tribulations on the Runway
FOR INQUIRING MINDS
You probably don’t spend much time worrying about the trials and tribulations of
fashion models. Most of them don’t lead
glamorous lives; in fact, except for a lucky
few, life as a fashion model today can be
very trying and not very lucrative. And it’s
all because of supply and demand.
Consider the case of Bianca Gomez,
a willowy 18-year-old from Los Angeles,
with green eyes, honey-colored hair, and
flawless skin, whose experience was
detailed in a Wall Street Journal article.
Bianca began modeling while still in high
school, earning about $30,000 in modeling fees during her senior year. Having
attracted the interest of some top
designers in New York, she moved there
after graduation, hoping to land jobs
in leading fashion houses and photoshoots for leading fashion magazines.
But once in New York, Bianca
entered the global market for fashion
models. And it wasn’t very pretty. Due
to the ease of transmitting photos electronically and the relatively low cost of
international travel, top fashion centers
such as New York and Milan, Italy, are
deluged each year with thousands of
beautiful young women from all over the
world, eagerly trying to make it as models. Although Russians, other Eastern
Europeans, and Brazilians are particular-
The global market for fashion models is not
at all pretty.
ly numerous, some hail from places such
as Kazakhstan and Mozambique.
Returning to our (less glamorous)
economic model of supply and demand,
the influx of aspiring fashion models from
around the world can be represented
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94
by a rightward shift of the supply curve
in the market for fashion models, which
would by itself tend to lower the price
paid to models.
And that wasn’t the only change in
the market. Unfortunately for Bianca
and others like her, the tastes of many
of those who hire models have changed
as well. Fashion magazines have come
to prefer using celebrities such as
Beyoncé on their pages rather than
anonymous models, believing that their
readers connect better with a familiar
face. This amounts to a leftward shift
of the demand curve for models—again
reducing the equilibrium price paid to
them.
This was borne out in Bianca’s
experiences. After paying her rent,
her transportation, all her modeling
expenses, and 20% of her earnings to
her modeling agency (which markets
her to prospective clients and books her
jobs), Bianca found that she was barely
breaking even. Sometimes she even had
to dip into savings from her high school
years. To save money, she ate macaroni
and hot dogs; she traveled to auditions,
often four or five in one day, by subway.
As the Wall Street Journal reported,
Bianca was seriously considering quitting modeling altogether.
•
In general, when supply and demand shift in opposite directions, we can’t
predict what the ultimate effect will be on the quantity bought and sold. What we
can say is that a curve that shifts a disproportionately greater distance than the
other curve will have a disproportionately greater effect on the quantity bought
and sold. That said, we can make the following prediction about the outcome
when the supply and demand curves shift in opposite directions:
• When demand decreases and supply increases, the equilibrium price falls but
the change in the equilibrium quantity is ambiguous.
• When demand increases and supply decreases, the equilibrium price rises but
the change in the equilibrium quantity is ambiguous.
But suppose that the demand and supply curves shift in the same direction.
This is what has happened in recent years in the United States, as the economy
has made a gradual recovery from the recession of 2008, resulting in an increase
in both demand and supply. Can we safely make any predictions about the
changes in price and quantity? In this situation, the change in quantity bought
and sold can be predicted, but the change in price is ambiguous. The two possible
outcomes when the supply and demand curves shift in the same direction (which
you should check for yourself) are as follows:
• When both demand and supply increase, the equilibrium quantity rises but
the change in equilibrium price is ambiguous.
• When both demand and supply decrease, the equilibrium quantity falls but
the change in equilibrium price is ambiguous.
in Action
S U P P LY A N D D E M A N D
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CHAPTER 3
The Cotton Panic and Crash of 2011
W
hen fear of a future price increase strikes a large enough number of
consumers, it can become a self-fulfilling prophecy. Much to the dismay of owners of cotton textile mills, this is exactly
what happened in early 2011, when a huge surge in the price
Cotton Prices in the United
FIGURE 3-17
of raw cotton peaked, followed by an equally spectacular
States, 1999–2013
fall. In situations like these, consumers become their own
Price
worst enemy, engaging in what is called panic buying: rush(per pound)
The price for raw
ing to purchase more of a good because its price has gone
cotton spiked in
$2.50
up, which precipitates only a further price rise and more
the United States
in 2011.
panic buying. So how did cotton buyers find themselves in
2.00
this predicament in 2011? And what finally got them out
of it?
1.50
The process had, in fact, been started by real events
1.00
that occurred years earlier. By 2010, demand for cotton had
rebounded sharply from lows set during the global finan0.50
cial crisis of 2006–2007. In addition, greater demand for
cotton clothing in countries with rapidly growing middle
1999 2001 2003 2005 2007 2009 2011 2013
classes, like China, added to the increased demand for
Year
cotton. This had the effect of shifting the demand curve
Source: USDA.
rightward.
At the same time there were significant supply reductions
to the worldwide market for cotton. India, the second largest exporter of cotton
Quick Review
(an exporter is a seller of a good to foreign buyers), had imposed restrictions on
• Changes in the equilibrium
the sale of its cotton abroad in order to aid its own textile mills. And Pakistan,
price and quantity in a market
China, and Australia, which were big growers of cotton, experienced widespread
result from shifts of the supply
curve, the demand curve, or both.
flooding that significantly reduced their cotton crops. The Indian export restrictions and the floods in cotton-producing areas had the effect of shifting the sup• An increase in demand increases
ply curve leftward.
both the equilibrium price and
the equilibrium quantity. A
So, as shown in Figure 3-17, while cotton had traded at between $0.35 and
decrease in demand decreases
$0.60 per pound from 2000 to 2010, it surged to more than $2.40 per pound in
both the equilibrium price and the
early 2011—up more than 200% in one year. As high prices for cotton sparked
equilibrium quantity.
panic buying, the demand curve shifted further rightward, further feeding the
•
An increase in supply drives
buying frenzy.
the equilibrium price down but
Yet by the end of 2011, cotton prices had plummeted to $0.86 per pound.
increases the equilibrium quantity.
What happened? A number of things, illustrating the forces of supply and
A decrease in supply raises the
demand. First, demand fell as clothing manufacturers, unwilling to pass on
equilibrium price but reduces the
huge price increases to their customers, shifted to less expensive fabrics like
equilibrium quantity.
polyester. Second, supply increased as farmers planted more acreage of cot• Often fluctuations in markets
ton in hopes of garnering high prices. As the effects of supply and demand
involve shifts of both the supply
became obvious, buyers stopped panicking and cotton prices finally fell back
and demand curves. When they
shift in the same direction, the
down to earth.
Check Your Understanding
3-4
1. In each of the following examples, determine (i) the market in question; (ii) whether
a shift in demand or supply occurred, the direction of the shift, and what induced
the shift; and (iii) the effect of the shift on the equilibrium price and the equilibrium quantity.
a. A s the price of gasoline fell in the United States during the 1990s, more people
bought large cars.
b. A s technological innovation has lowered the cost of recycling used paper, fresh
paper made from recycled stock is used more frequently.
c. When a local cable company offers cheaper on-demand films, local movie theaters have more unfilled seats.
change in equilibrium quantity
is predictable but the change in
equilibrium price is not. When
they shift in opposite directions,
the change in equilibrium price
is predictable but the change in
equilibrium quantity is not. When
there are simultaneous shifts of
the demand and supply curves,
the curve that shifts the greater
distance has a greater effect on the
change in equilibrium price and
quantity.
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2. When a new, faster computer chip is introduced, demand for computers using
the older, slower chips decreases. Simultaneously, computer makers increase
their production of computers containing the old chips in order to clear out their
stocks of old chips.
Draw two diagrams of the market for computers containing the old chips:
a. one in which the equilibrium quantity falls in response to these events and
b. one in which the equilibrium quantity rises.
c. What happens to the equilibrium price in each diagram?
Solutions appear at back of book.
Competitive Markets—And Others
Early in this chapter, we defined a competitive market and explained that the
supply and demand framework is a model of competitive markets. But we took a
rain check on the question of why it matters whether or not a market is competitive. Now that we’ve seen how the supply and demand model works, we can offer
some explanation.
To understand why competitive markets are different from other markets,
compare the problems facing two individuals: a wheat farmer who must decide
whether to grow more wheat and the president of a giant aluminum company—
say, Alcoa—who must decide whether to produce more aluminum.
For the wheat farmer, the question is simply whether the extra wheat can be
sold at a price high enough to justify the extra production cost. The farmer need
not worry about whether producing more wheat will affect the price of the wheat
he or she was already planning to grow. That’s because the wheat market is competitive. There are thousands of wheat farmers, and no one farmer’s decision will
have any impact on the market price.
For the Alcoa executive, things are not that simple because the aluminum market is not competitive. There are only a few big producers, including Alcoa, and each
of them is well aware that its actions do have a noticeable impact on the market
price. This adds a whole new level of complexity to the decisions producers have to
make. Alcoa can’t decide whether or not to produce more aluminum just by asking
whether the additional product will sell for more than it costs to make. The company also has to ask whether producing more aluminum will drive down the market price and reduce its profit, its net gain from producing and selling its output.
When a market is competitive, individuals can base decisions on less complicated analyses than those used in a noncompetitive market. This in turn means
that it’s easier for economists to build a model of a competitive market than of a
noncompetitive market.
Don’t take this to mean that economic analysis has nothing to say about noncompetitive markets. On the contrary, economists can offer some very important
insights into how other kinds of markets work. But those insights require other
models, which we will learn about later on.
CASE
An Uber Way to Get a Ride
I
n a densely populated city like New York City, finding a taxi is a relatively easy
task on most days—stand on a corner, put out your arm and, usually, before
long an available cab stops to pick you up. And even before you step into the
car you will know approximately how much it will cost to get to your destination,
because taxi meter rates are set by city regulators and posted for riders.
But at times it is not so easy to find a taxi—on rainy days, during rush hour,
and at crowded locations where many people are looking for a taxi at the
same time. At such times, you could wait a very long while before finding
an available cab. As you wait, you will probably notice empty taxis passing you by—drivers who have quit working for the day and are headed
home or back to the garage. There will be drivers who might stop, but
then won’t pick you up because they find your destination inconvenient.
Moreover, there are times when it is simply impossible to hail a taxi—for
example, during a snowstorm or on New Year’s Eve when the demand for
taxis far exceeds the supply.
In 2009 two young entrepreneurs, Garrett Camp and Travis Kalanick,
founded Uber, a company that they believe offers a better way to get a ride.
Using a smartphone app, Uber serves as a clearinghouse connecting people
who want a ride to drivers with cars who are registered with Uber. Confirm
your location using the Uber app and you’ll be shown the available cars in
your vicinity. Tap “book” and you receive a text saying your car—typically a
spotless Lincoln Town Car—is on its way. At the end of your trip, fare plus tip
are automatically deducted from your credit card. As of 2014 Uber operates in
70 cities around the world and booked more than $1 billion in rides in 2013.
Given that Uber provides personalized service and better quality cars, their
fares are somewhat higher than regular taxi fares during normal driving days—a
situation that customers seem happy with. However, the qualification during normal driving hours is an important one because at other times Uber’s rates fluctuate. When a lot of people are looking for a car—such as during a snowstorm or on
New Year’s Eve—Uber uses what it calls surge pricing, setting the rate higher until
everyone who wants a car at the going price can get one. So during a recent New
York snowstorm, rides cost up to 8.25 times the standard price. Enraged, some of
Uber’s customers have accused them of price gouging.
But according to Kalanick, the algorithm that Uber uses to determine the
surge price is set to leave as few people as possible without a ride, and he’s just
doing what is necessary to keep customers happy. As he explains, “We do not own
cars nor do we employ drivers. Higher prices are required in order to get cars on
the road and keep them on the road during the busiest times.” This explanation
was confirmed by one Uber driver who said, “If I don’t have anything to do and
see a surge price, I get out there.”
Mark Avery/Zuma Wire/Alamy
BUSINESS
QUESTIONS FOR THOUGHT
1. Before Uber, how were prices set in the market for rides in New York City?
Was it a competitive market?
2. What accounts for the fact that during good weather there are typically
enough taxis for everyone who wants one, but during snowstorms there typically aren’t enough?
3. How does Uber’s surge pricing solve the problem described in the previous
question? Assess Kalanick’s claim that the price is set to leave as few people
possible without a ride.
97
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SUMMARY
a competitive market, one with many buyers
and sellers, none of whom can influence the market
price, works.
ing supply, they mean shifts of the supply curve—a
change in the quantity supplied at any given price. An
increase in supply causes a rightward shift of the supply curve. A decrease in supply causes a leftward shift.
2. The demand schedule shows the quantity demand-
8. There are five main factors that shift the supply curve:
1. The supply and demand model illustrates how
ed at each price and is represented graphically by
a demand curve. The law of demand says that
demand curves slope downward; that is, a higher
price for a good or service leads people to demand a
smaller quantity, other things equal.
3. A movement along the demand curve occurs when a
price change leads to a change in the quantity demanded. When economists talk of increasing or decreasing
demand, they mean shifts of the demand curve—a
change in the quantity demanded at any given price.
An increase in demand causes a rightward shift of the
demand curve. A decrease in demand causes a leftward
shift.
4. There are five main factors that shift the demand
curve:
• A
change in the prices of related goods or services,
such as substitutes or complements
• A
change in income: when income rises, the demand
for normal goods increases and the demand for
inferior goods decreases
• A change in tastes
• A change in expectations
• A change in the number of consumers
5. The market demand curve for a good or service is the
horizontal sum of the individual demand curves of
all consumers in the market.
6. The supply schedule shows the quantity supplied at
each price and is represented graphically by a supply
curve. Supply curves usually slope upward.
7. A movement along the supply curve occurs when
a price change leads to a change in the quantity supplied. When economists talk of increasing or decreas-
• A change in input prices
• A change in the prices of related goods and services
• A change in technology
• A change in expectations
• A change in the number of producers
9. The market supply curve for a good or service is the
horizontal sum of the individual supply curves of all
producers in the market.
10. The supply and demand model is based on the princi-
ple that the price in a market moves to its equilibrium
price, or market-clearing price, the price at which
the quantity demanded is equal to the quantity supplied. This quantity is the equilibrium quantity. When
the price is above its market-clearing level, there is a
surplus that pushes the price down. When the price is
below its market-clearing level, there is a shortage that
pushes the price up.
11. An increase in demand increases both the equilib-
rium price and the equilibrium quantity; a decrease in
demand has the opposite effect. An increase in supply
reduces the equilibrium price and increases the equilibrium quantity; a decrease in supply has the opposite
effect.
12. Shifts of the demand curve and the supply curve can
happen simultaneously. When they shift in opposite
directions, the change in equilibrium price is predictable but the change in equilibrium quantity is not.
When they shift in the same direction, the change in
equilibrium quantity is predictable but the change
in equilibrium price is not. In general, the curve that
shifts the greater distance has a greater effect on the
changes in equilibrium price and quantity.
KEY TERMS
Competitive market, p. 68
Supply and demand model, p. 68
Demand schedule, p. 69
Quantity demanded, p. 69
Demand curve, p. 69
Law of demand, p. 70
Shift of the demand curve, p. 72
Movement along the demand curve,
p. 72
Substitutes, p. 74
Complements, p. 74
Normal good, p. 74
Inferior good, p. 74
Individual demand curve, p. 76
Quantity supplied, p. 79
Supply schedule, p. 79
Supply curve, p. 79
Shift of the supply curve, p. 80
Movement along the supply curve,
p. 80
Input, p. 82
Individual supply curve, p. 83
Equilibrium price, p. 86
Equilibrium quantity, p. 86
Market-clearing price, p. 86
Surplus, p. 88
Shortage, p. 88
CHAPTER 3
S U P P LY A N D D E M A N D
99
PROBLEMS
1. A survey indicated that chocolate is the most popular
flavor of ice cream in America. For each of the following, indicate the possible effects on demand, supply, or
both as well as equilibrium price and quantity of chocolate ice cream.
a. A severe drought in the Midwest causes dairy farmers
to reduce the number of milk-producing cattle in their
herds by a third. These dairy farmers supply cream
that is used to manufacture chocolate ice cream.
b. A new report by the American Medical Association
reveals that chocolate does, in fact, have significant
health benefits.
c. The discovery of cheaper synthetic vanilla flavoring
lowers the price of vanilla ice cream.
d. New technology for mixing and freezing ice cream
lowers manufacturers’ costs of producing chocolate
ice cream.
2. In a supply and demand diagram, draw the shift of the
demand curve for hamburgers in your hometown due
to the following events. In each case, show the effect on
equilibrium price and quantity.
a. The price of tacos increases.
b. All hamburger sellers raise the price of their french
fries.
c. Income falls in town. Assume that hamburgers are a
b. The market for St. Louis Rams cotton T-shirts
Case 1: The Rams win the Super Bowl.
Case 2: The price of cotton increases.
c. The market for bagels
Case 1: People realize how fattening bagels are.
Case 2: People have less time to make themselves a
cooked breakfast.
d. The market for the Krugman and Wells economics
textbook
Case 1: Your professor makes it required reading for
all of his or her students.
Case 2: Printing costs for textbooks are lowered by
the use of synthetic paper.
5. Let’s assume that each person in the United States con-
sumes an average of 37 gallons of soft drinks (nondiet)
at an average price of $2 per gallon and that the U.S.
population is 294 million. At a price of $1.50 per gallon,
each individual consumer would demand 50 gallons of
soft drinks. From this information about the individual
demand schedule, calculate the market demand schedule for soft drinks for the prices of $1.50 and $2 per
gallon.
6. Suppose that the supply schedule of Maine lobsters is as
follows:
normal good for most people.
d. Income falls in town. Assume that hamburgers are
an inferior good for most people.
e. Hot dog stands cut the price of hot dogs.
3. The market for many goods changes in predictable ways
according to the time of year, in response to events such
as holidays, vacation times, seasonal changes in production, and so on. Using supply and demand, explain
the change in price in each of the following cases. Note
that supply and demand may shift simultaneously.
a. Lobster prices usually fall during the summer peak
lobster harvest season, despite the fact that people
like to eat lobster during the summer more than at
any other time of year.
b. The price of a Christmas tree is lower after
Christmas than before but fewer trees are sold.
c. The price of a round-trip ticket to Paris on Air
France falls by more than $200 after the end of
school vacation in September. This happens despite
the fact that generally worsening weather increases
the cost of operating flights to Paris, and Air France
therefore reduces the number of flights to Paris at
any given price.
4. Show in a diagram the effect on the demand curve, the
supply curve, the equilibrium price, and the equilibrium quantity of each of the following events.
a. The market for newspapers in your town
Case 1: The salaries of journalists go up.
Case 2: There is a big news event in your town,
which is reported in the newspapers.
Price of lobster
(per pound)
Quantity of lobster
supplied (pounds)
$25
800
20
700
15
600
10
500
5
400
Suppose that Maine lobsters can be sold only in the
United States. The U.S. demand schedule for Maine
lobsters is as follows:
Price of lobster
(per pound)
Quantity of lobster
demanded (pounds)
$25
200
20
400
15
600
10
800
5
1,000
a. Draw the demand curve and the supply curve for
Maine lobsters. What are the equilibrium price and
quantity of lobsters?
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Now suppose that Maine lobsters can be sold in France.
The French demand schedule for Maine lobsters is as
follows:
Price of lobster
(per pound)
Quantity of lobster
supplied (pounds)
$25
100
20
300
15
500
10
700
5
900
b. What is the demand schedule for Maine lobsters
now that French consumers can also buy them?
Draw a supply and demand diagram that illustrates the new equilibrium price and quantity
of lobsters. What will happen to the price at
which fishermen can sell lobster? What will
happen to the price paid by U.S. consumers?
What will happen to the quantity consumed by
U.S. consumers?
7. Find the flaws in reasoning in the following statements,
paying particular attention to the distinction between
shifts of and movements along the supply and demand
curves. Draw a diagram to illustrate what actually happens in each situation.
a. “A technological innovation that lowers the cost of
producing a good might seem at first to result in a
reduction in the price of the good to consumers. But
a fall in price will increase demand for the good,
and higher demand will send the price up again.
It is not certain, therefore, that an innovation will
really reduce price in the end.”
b. “A study shows that eating a clove of garlic a
day can help prevent heart disease, causing
many consumers to demand more garlic. This
increase in demand results in a rise in the price
of garlic. Consumers, seeing that the price of
garlic has gone up, reduce their demand for
garlic. This causes the demand for garlic to decrease
and the price of garlic to fall. Therefore, the ultimate
effect of the study on the price of
garlic is uncertain.”
8. The following table shows a demand schedule for a nor-
mal good.
Price
Quantity demanded
$23
70
21
90
19
110
17
130
a. Do you think that the increase in quantity demand-
ed (say, from 90 to 110 in the table) when price
decreases (from $21 to $19) is due to a rise in consumers’ income? Explain clearly (and briefly) why or
why not.
b. Now suppose that the good is an inferior good.
Would the demand schedule still be valid for an
inferior good?
c. Lastly, assume you do not know whether the good is
normal or inferior. Devise an experiment that would
allow you to determine which one it was. Explain.
9. In recent years, the number of car producers in China
has increased rapidly. In fact, China now has more
car brands than the United States. In addition, car
sales have climbed every year and automakers have
increased their output at even faster rates, causing
fierce competition and a decline in prices. At the same
time, Chinese consumers’ incomes have risen. Assume
that cars are a normal good. Draw a diagram of the
supply and demand curves for cars in China to explain
what has happened in the Chinese car market.
10. Aaron Hank is a star hitter for the Bay City baseball
team. He is close to breaking the major league record
for home runs hit during one season, and it is widely
anticipated that in the next game he will break that
record. As a result, tickets for the team’s next game have
been a hot commodity. But today it is announced that,
due to a knee injury, he will not in fact play in the team’s
next game. Assume that season ticket-holders are able to
resell their tickets if they wish. Use supply and demand
diagrams to explain your answers to parts a and b.
a. Show the case in which this announcement results
in a lower equilibrium price and a lower equilibrium
quantity than before the announcement.
b. Show the case in which this announcement results
in a lower equilibrium price and a higher equilibrium quantity than before the announcement.
c. What accounts for whether case a or case b occurs?
d. Suppose that a scalper had secretly learned before
the announcement that Aaron Hank would not play
in the next game. What actions do you think he
would take?
11. Fans of rock and rock stars often bemoan the high
price of concert tickets. One superstar has argued that
it isn’t worth hundreds, even thousands, of dollars to
hear him and his band play. Let’s assume this star sold
out arenas around the country at an average ticket
price of $75.
a. How would you evaluate the argument that ticket
prices are too high?
b. Suppose that due to this star’s protests, ticket prices
were lowered to $50. In what sense is this price too
low? Draw a diagram using supply and demand
curves to support your argument.
c. Suppose the rock superstar really wanted to bring
down ticket prices. Since he and his band control the
supply of their services, what do you recommend they
do? Explain using a supply and demand diagram.
d. Suppose the band’s next album was a total dud.
Do you think they would still have to worry about
ticket prices being too high? Why or why not?
Draw a supply and demand diagram to support
your argument.
CHAPTER 3
e. Suppose the group announced their next tour
was going to be their last. What effect would this
likely have on the demand for and price of tickets?
Illustrate with a supply and demand diagram.
12. After several years of decline, the market for handmade
acoustic guitars is making a comeback. These guitars
are usually made in small workshops employing relatively few highly skilled luthiers. Assess the impact on
the equilibrium price and quantity of handmade acoustic guitars as a result of each of the following events.
In your answers indicate which curve(s) shift(s) and in
which direction.
a. Environmentalists succeed in having the use of
Brazilian rosewood banned in the United States,
forcing luthiers to seek out alternative, more costly
woods.
b. A foreign producer reengineers the guitar-making
process and floods the market with identical guitars.
c. Music featuring handmade acoustic guitars makes
a comeback as audiences tire of heavy metal and
alternative rock music.
d. The country goes into a deep recession and the
income of the average American falls sharply.
13. Demand twisters: Sketch and explain the demand rela-
tionship in each of the following statements.
a. I would never buy a Miley Cyrus album! You
couldn’t even give me one for nothing.
b. I generally buy a bit more coffee as the price falls.
But once the price falls to $2 per pound, I’ll buy out
the entire stock of the supermarket.
c. I spend more on orange juice even as the price rises.
(Does this mean that I must be violating the law of
demand?)
d. Due to a tuition rise, most students at a college find
themselves with less disposable income. Almost all
of them eat more frequently at the school cafeteria
and less often at restaurants, even though prices at
the cafeteria have risen, too. (This one requires that
you draw both the demand and the supply curves for
school cafeteria meals.)
14. Will Shakespeare is a struggling playwright in
sixteenth-century London. As the price he receives
for writing a play increases, he is willing to write
more plays. For the following situations, use a
diagram to illustrate how each event affects the
equilibrium price and quantity in the market for
Shakespeare’s plays.
a. The playwright Christopher Marlowe, Shakespeare’s
chief rival, is killed in a bar brawl.
b. The bubonic plague, a deadly infectious disease,
breaks out in London.
c. To celebrate the defeat of the Spanish Armada,
Queen Elizabeth declares several weeks of
festivities, which involves commissioning new
plays.
S U P P LY A N D D E M A N D
101
15. This year, the small town of Middling experiences a
sudden doubling of the birth rate. After three years, the
birth rate returns to normal. Use a diagram to illustrate
the effect of these events on the following.
a. The market for an hour of babysitting services in
Middling this year
b. The market for an hour of babysitting services
14 years into the future, after the birth rate has
returned to normal, by which time children born
today are old enough to work as babysitters
c. The market for an hour of babysitting services
30 years into the future, when children born today
are likely to be having children of their own
16. Use a diagram to illustrate how each of the following
events affects the equilibrium price and quantity of
pizza.
a. The price of mozzarella cheese rises.
b. The health hazards of hamburgers are widely
publicized.
c. The price of tomato sauce falls.
d. The incomes of consumers rise and pizza is an infe-
rior good.
e. Consumers expect the price of pizza to fall next
week.
17. Although he was a prolific artist, Pablo Picasso painted
only 1,000 canvases during his “Blue Period.” Picasso is
now dead, and all of his Blue Period works are currently
on display in museums and private galleries throughout
Europe and the United States.
a. Draw a supply curve for Picasso Blue Period works.
Why is this supply curve different from ones you
have seen?
b. Given the supply curve from part a, the price
of a Picasso Blue Period work will be entirely
dependent on what factor(s)? Draw a diagram
showing how the equilibrium price of such a
work is determined.
c. Suppose rich art collectors decide that it is essential
to acquire Picasso Blue Period art for their collections. Show the impact of this on the market for
these paintings.
18. Draw the appropriate curve in each of the following
cases. Is it like or unlike the curves you have seen so
far? Explain.
a. The demand for cardiac bypass surgery, given that
the government pays the full cost for any patient
b. The demand for elective cosmetic plastic surgery,
given that the patient pays the full cost
c. The supply of reproductions of Rembrandt paintings
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WORK IT OUT
For interactive, step-by-step help in solving the following problem,
visit
by using the URL on the back cover of this book.
19. The accompanying table gives the annual U.S. demand
and supply schedules for pickup trucks.
Price of truck
Quantity of
trucks demanded
(millions)
Quantity of
trucks supplied
(millions)
$20,000
20
14
25,000
18
15
30,000
16
16
35,000
14
17
40,000
12
18
a. Plot the demand and supply curves using these
schedules. Indicate the equilibrium price and
quantity on your diagram.
b. Suppose the tires used on pickup trucks are
found to be defective. What would you expect to
happen in the market for pickup trucks? Show
this on your diagram.
c Suppose that the U.S. Department of
Transportation imposes costly regulations on
manufacturers that cause them to reduce supply
by one-third at any given price. Calculate and plot
the new supply schedule and indicate the new
equilibrium price and quantity on your diagram.
CHAPTER
Price Controls and Quotas:
Meddling with Markets
4
BIG CITY, NOT-SO-BRIGHT IDEAS
s
What You Will Learn
in This Chapter
meaning of price controls
•andThequantity
controls, two kinds
of government intervention in
markets
How price and quantity controls
•create
problems and can make a
market inefficient
•
Why the predictable side effects
of intervention in markets often
lead economists to be skeptical of
its usefulness
why they are used despite their
well-known problems
©UpperCut Images/Alamy
Who benefits and who loses
•from
market interventions, and
New York City: an empty taxi is hard to find.
N
EW YORK CITY IS A PLACE
where you can find almost
anything—that is, anything,
except a taxicab when you need one
or a decent apartment at a rent you
can afford. You might think that New
York’s notorious shortages of cabs and
apartments are the inevitable price of
big-city living. However, they are largely
the product of government policies—
specifically, of government policies that
have, one way or another, tried to prevail
over the market forces of supply and
demand.
In Chapter 3, we learned the principle
that a market moves to equilibrium—
that the market price rises or falls to the
level at which the quantity of a good that
people are willing to supply is equal to
the quantity that other people demand.
But sometimes governments try to
defy that principle. Whenever a government tries to dictate either a market
price or a market quantity that’s different
from the equilibrium price or quantity,
the market strikes back in predictable
ways. Our ability to predict what will
happen when governments try to defy
supply and demand shows the power
and usefulness of supply and demand
analysis itself.
The shortages of apartments and
taxicabs in New York are two examples
that illuminate what happens when the
logic of the market is defied.
New York’s housing shortage is
the result of rent control, a law that
prevents landlords from raising rents
except when specifically given permission. Rent control was introduced
during World War II to protect the
interests of tenants, and it still remains
in force. Many other American cities
have had rent control at one time or
another, but with the notable exceptions of New York and San Francisco,
these controls have largely been done
away with.
Similarly, New York’s limited supply
of taxis is the result of a licensing system
introduced in the 1930s. New York taxi
licenses are known as “medallions,” and
only taxis with medallions are allowed to
pick up passengers. Although this system was originally intended to protect
the interests of both drivers and customers, it has generated a shortage of taxis
in the city. The number of medallions
remained fixed for nearly 60 years, with
no significant increase until 2004 and
only a trickle since.
In this chapter, we begin by examining what happens when governments try
to control prices in a competitive market,
keeping the price in a market either
below its equilibrium level—a price
ceiling such as rent control—or above
it—a price floor such as the minimum
wage paid to workers in many countries.
We then turn to schemes such as taxi
medallions that attempt to dictate the
quantity of a good bought and sold.
103
104 P A R T 2
S U P P LY A N D D E M A N D
Price controls are legal restrictions
on how high or low a market price
may go. They can take two forms:
a price ceiling, a maximum price
sellers are allowed to charge for a
good or service, or a price floor, a
minimum price buyers are required to
pay for a good or service.
Why Governments Control Prices
You learned in Chapter 3 that a market moves to equilibrium—that is, the market price moves to the level at which the quantity supplied equals the quantity
demanded. But this equilibrium price does not necessarily please either buyers
or sellers.
After all, buyers would always like to pay less if they could, and sometimes
they can make a strong moral or political case that they should pay lower prices.
For example, what if the equilibrium between supply and demand for apartments
in a major city leads to rental rates that an average working person can’t afford?
In that case, a government might well be under pressure to impose limits on the
rents landlords can charge.
Sellers, however, would always like to get more money for what they sell, and
sometimes they can make a strong moral or political case that they should receive
higher prices. For example, consider the labor market: the price for an hour of
a worker’s time is the wage rate. What if the equilibrium between supply and
demand for less skilled workers leads to wage rates that yield an income below
the poverty level? In that case, a government might well be pressured to require
employers to pay a rate no lower than some specified minimum wage.
In other words, there is often a strong political demand for governments to
intervene in markets. And powerful interests can make a compelling case that a
market intervention favoring them is “fair.” When a government intervenes to regulate prices, we say that it imposes price controls. These controls typically take
the form either of an upper limit, a price ceiling, or a lower limit, a price floor.
Unfortunately, it’s not that easy to tell a market what to do. As we will now
see, when a government tries to legislate prices—whether it legislates them down
by imposing a price ceiling or up by imposing a price floor—there are certain
predictable and unpleasant side effects.
We make an important assumption in this chapter: the markets in question
are efficient before price controls are imposed. But markets can sometimes be
inefficient—for example, a market dominated by a monopolist, a single seller that
has the power to influence the market price. When markets are inefficient, price
controls don’t necessarily cause problems and can potentially move the market
closer to efficiency.
In practice, however, price controls are often imposed on efficient markets—
like the New York apartment market. And so the analysis in this chapter applies
to many important real-world situations.
Price Ceilings
Aside from rent control, there are not many price ceilings in the United States
today. But at times they have been widespread. Price ceilings are typically
imposed during crises—wars, harvest failures, natural disasters—because these
events often lead to sudden price increases that hurt many people but produce
big gains for a lucky few.
The U.S. government imposed ceilings on many prices during World War II:
the war sharply increased demand for raw materials, such as aluminum and steel,
and price controls prevented those with access to these raw materials from earning huge profits. Price controls on oil were imposed in 1973, when an embargo
by Arab oil-exporting countries seemed likely to generate huge profits for U.S. oil
companies. Price controls were instituted again in 2012 by New York and New
Jersey authorities in the aftermath of Hurricane Sandy, as gas shortages led to
rampant price-gouging.
Rent control in New York is, believe it or not, a legacy of World War II: it
was imposed because wartime production produced an economic boom, which
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increased demand for apartments at a time when the labor and raw materials
that might have been used to build them were being used to win the war instead.
Although most price controls were removed soon after the war ended, New York’s
rent limits were retained and gradually extended to buildings not previously covered, leading to some very strange situations.
You can rent a one-bedroom apartment in Manhattan on fairly short notice—
if you are able and willing to pay several thousand dollars a month and live in
a less desirable area. Yet some people pay only a small fraction of this for comparable apartments, and others pay hardly more for bigger apartments in better
locations.
Aside from producing great deals for some renters, however, what are the
broader consequences of New York’s rent-control system? To answer this question,
we turn to the model we developed in Chapter 3: the supply and demand model.
Modeling a Price Ceiling
To see what can go wrong when a government imposes a price ceiling on an
efficient market, consider Figure 4-1, which shows a simplified model of the
market for apartments in New York. For the sake of simplicity, we imagine that
all apartments are exactly the same and so would rent for the same price in an
unregulated market.
The table in Figure 4-1 shows the demand and supply schedules; the demand
and supply curves are shown on the left. We show the quantity of apartments on
the horizontal axis and the monthly rent per apartment on the vertical axis. You
can see that in an unregulated market the equilibrium would be at point E: 2 million apartments would be rented for $1,000 each per month.
Now suppose that the government imposes a price ceiling, limiting rents to a
price below the equilibrium price—say, no more than $800.
FIGURE 4-1
The Market for Apartments in the Absence of Price Controls
Monthly rent
(per apartment)
$1,400
Quantity
(per apartment) demanded
1,200
1,000
(millions)
Monthly rent
1,300
1,100
Quantity of apartments
S
E
900
800
700
600
D
0
1.6 1.7 1.8 1.9 2.0 2.1 2.2 2.3 2.4
Quantity of apartments (millions)
Without government intervention, the market for
apartments reaches equilibrium at point E with a market
$1,400
1,300
1,200
1,100
1,000
900
800
700
600
1.6
1.7
1.8
1.9
2.0
2.1
2.2
2.3
2.4
Quantity
supplied
2.4
2.3
2.2
2.1
2.0
1.9
1.8
1.7
1.6
rent of $1,000 per month and 2 million apartments
rented.
105
106 P A R T 2
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FIGURE 4-2
The Effects of a Price Ceiling
The black horizontal line represents
the government-imposed price
ceiling on rents of $800 per month.
This price ceiling reduces the
quantity of apartments supplied to
1.8 million, point A, and increases
the quantity demanded to 2.2 million,
point B. This creates a persistent
shortage of 400,000 units: 400,000
people who want apartments at the
legal rent of $800 but cannot get
them.
Monthly rent
(per apartment)
S
$1,400
1,200
E
1,000
A
800
Housing shortage
of 400,000
apartments caused
by price ceiling
600
0
B
Price
ceiling
1.6
D
1.8
2.0
2.2
2.4
Quantity of apartments (millions)
Figure 4-2 shows the effect of the price ceiling, represented by the line at $800.
At the enforced rental rate of $800, landlords have less incentive to offer apartments, so they won’t be willing to supply as many as they would at the equilibrium rate of $1,000. They will choose point A on the supply curve, offering only
1.8 million apartments for rent, 200,000 fewer than in the unregulated market.
At the same time, more people will want to rent apartments at a price of $800
than at the equilibrium price of $1,000; as shown at point B on the demand curve,
at a monthly rent of $800 the quantity of apartments demanded rises to 2.2 million, 200,000 more than in the unregulated market and 400,000 more than are
actually available at the price of $800. So there is now a persistent shortage of
rental housing: at that price, 400,000 more people want to rent than are able to
find apartments.
Do price ceilings always cause shortages? No. If a price ceiling is set above the
equilibrium price, it won’t have any effect. Suppose that the equilibrium rental
rate on apartments is $1,000 per month and the city government sets a ceiling of
$1,200. Who cares? In this case, the price ceiling won’t be binding—it won’t actually constrain market behavior—and it will have no effect.
How a Price Ceiling Causes Inefficiency
The housing shortage shown in Figure 4-2 is not merely annoying: like any shortage induced by price controls, it can be seriously harmful because it leads to inefficiency. In other words, there are gains from trade that go unrealized.
Rent control, like all price ceilings, creates inefficiency in at least four distinct ways.
1. It reduces the quantity of apartments rented below the efficient level.
2. It typically leads to inefficient allocation of apartments among would-be renters.
3. It leads to wasted time and effort as people search for apartments.
4. It leads landlords to maintain apartments in inefficiently low quality or condition.
In addition to inefficiency, price ceilings give rise to illegal behavior as people
try to circumvent them. We’ll now look at each of these inefficiencies caused by
price ceilings.
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Inefficiently Low Quantity Because a price ceiling reduces the price of a good,
it reduces the quantity that sellers are willing to supply. Buyers can’t buy more
units of a good than sellers are willing to sell; a price ceiling reduces the quantity
of a good bought and sold below the market equilibrium quantity.
Because rent control reduces the number of apartments supplied, it reduces
the number of apartments rented, too. The low quantity sold is an inefficiency
due to missed opportunities: price ceilings prevent mutually beneficial transactions from occurring, transactions that would benefit both buyers and sellers.
Figure 4-3 shows the inefficiently low quantity of apartments supplied with rent
control.
Price ceilings often lead to
inefficiency in the form of inefficient
allocation to consumers: some
people who want the good badly and
are willing to pay a high price don’t
get it, and some who care relatively
little about the good and are only
willing to pay a low price do get it.
Inefficient Allocation to Consumers Rent control doesn’t just lead to too few
apartments being available. It can also lead to misallocation of the apartments that
are available: people who badly need a place to live may not be able to find an apartment, but some apartments may be occupied by people with much less urgent needs.
In the case shown in Figure 4-2, 2.2 million people would like to rent an
apartment at $800 per month, but only 1.8 million apartments are available.
Of those 2.2 million who are seeking an apartment, some want one badly and
are willing to pay a high price to get it. Others have a less urgent need and are
only willing to pay a low price, perhaps because they have alternative housing.
An efficient allocation of apartments would reflect these differences: people
who really want an apartment will get one and people who aren’t all that anxious
to find an apartment won’t. In an inefficient distribution of apartments, the opposite will happen: some people who are not especially anxious to find an apartment
will get one and others who are very anxious to find an apartment won’t.
Because people usually get apartments through luck or personal connections
under rent control, it generally results in an inefficient allocation to consumers
of the few apartments available.
To see the inefficiency involved, consider the plight of the Lees, a family with
young children who have no alternative housing and would be willing to pay up
FIGURE 4-3
A Price Ceiling Causes Inefficiently Low Quantity
A price ceiling reduces the
quantity supplied below the market
equilibrium quantity. Because buyers
can’t buy more units of a good than
sellers are willing to sell, a price
ceiling reduces the quantity of a
good bought and sold.
Monthly rent
(per apartment)
S
$1,400
1,200
E
1,000
Price
ceiling
800
600
0
D
1.6
1.8
Quantity supplied
with rent control
2.0
107
2.2
2.4
Quantity of
apartments
Quantity supplied
without rent control (millions)
108 P A R T 2
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Price ceilings typically lead to
inefficiency in the form of wasted
resources: people expend money,
effort, and time to cope with the
shortages caused by the price
ceiling.
Price ceilings often lead to
inefficiency in that the goods being
offered are of inefficiently low
quality: sellers offer low-quality
goods at a low price even though
buyers would prefer a higher quality
at a higher price.
to $1,500 for an apartment—but are unable to find one. Also consider George,
a retiree who lives most of the year in Florida but still has a lease on the New
York apartment he moved into 40 years ago. George pays $800 per month for this
apartment, but if the rent were even slightly more—say, $850—he would give it
up and stay with his children when he visits New York.
This allocation of apartments—George has one and the Lees do not—is a
missed opportunity: there is a way to make the Lees and George both better
off at no additional cost. The Lees would be happy to pay George, say, $1,200
a month to sublease his apartment, which he would happily accept since the
apartment is worth no more than $849 a month to him. George would prefer the
money he gets from the Lees to keeping his apartment; the Lees would prefer to
have the apartment rather than the money. So both would be made better off by
this transaction—and nobody else would be made worse off.
Generally, if people who really want apartments could sublease them from
people who are less eager to live there, both those who gain apartments and those
who trade their occupancy for money would be better off. However, subletting is
illegal under rent control because it would occur at prices above the price ceiling.
The fact that subletting is illegal doesn’t mean it never happens. In fact, chasing down illegal subletting is a major business for New York private investigators.
An article in the New York Times described how private investigators use hidden
cameras and other tricks to prove that the legal tenants in rent-controlled apartments actually live somewhere else, and have sublet their apartments at two or
three times the controlled rent.
This subletting is a kind of illegal activity, which we will discuss shortly. For
now, just note that landlords and legal agencies actively discourage the practice.
As a result, the problem of inefficient allocation of apartments remains.
Wasted Resources Another reason a price ceiling causes inefficiency is that it
leads to wasted resources: people expend money, effort, and time to cope with
the shortages caused by the price ceiling. Back in 1979, U.S. price controls on
gasoline led to shortages that forced millions of Americans to wait on lines at
gas stations for hours each week. The opportunity cost of the time spent in gas
lines—the wages not earned, the leisure time not enjoyed—constituted wasted
resources from the point of view of consumers and of the economy as a whole.
Because of rent control, the Lees will spend all their spare time for several
months searching for an apartment, time they would rather have spent working
or in family activities. That is, there is an opportunity cost to the Lees’ prolonged
search for an apartment—the leisure or income they had to forgo.
If the market for apartments worked freely, the Lees would quickly find an
apartment at the equilibrium rent of $1,000, leaving them time to earn more
or to enjoy themselves—an outcome that would make them better off without
making anyone else worse off. Again, rent control creates missed opportunities.
Inefficiently Low Quality Yet another way a price ceiling creates inefficiency
is by causing goods to be of inefficiently low quality. Inefficiently low quality
means that sellers offer low-quality goods at a low price even though buyers
would rather have higher quality and would be willing to pay a higher price for it.
Again, consider rent control. Landlords have no incentive to provide better conditions because they cannot raise rents to cover their repair costs but
are able to find tenants easily. In many cases, tenants would be willing to
pay much more for improved conditions than it would cost for the landlord
to provide them—for example, the upgrade of an antiquated electrical system that cannot safely run air conditioners or computers. But any additional
payment for such improvements would be legally considered a rent increase,
which is prohibited.
Indeed, rent-controlled apartments are notoriously badly maintained, rarely
painted, subject to frequent electrical and plumbing problems, sometimes even
meet. Now, with redevelopment, these tenants have become multimillionaires overnight as capital values of the properties
they occupied soared.” According to him,
it is still a good deal for landlords, as newly
constructed five-bedroom apartments are
selling for $12.5 million.
But not all rent-controlled tenants
agree to leave. In one famous story, three
Dinodia Photos/Alamy
Just how costly is rent control for landlords? In Mumbai, India, the answer is
very high indeed. It is so high that thousands of rent-controlled tenants have
become millionaires upon vacating their
apartments.
In Mumbai, a magnet for a rapidly
expanding number of high-income Indians,
property prices rose by almost 70% in
four years, from 2009 to 2013. According
to real estate developer Pujit Agarwal, the
highly desirable area of South Mumbai,
hugging the Arabian Sea, is home to about
500 severely dilapidated stone structures
which, once redeveloped, would be worth
about $40 billion. But landlords and real
estate developers have to address the fact
that those dilapidated structures are occupied by rent-controlled tenants.
Take the case of Mea Kadwani, age 78,
who had been living since he was a toddler in the same 2,600-square-foot apartment where he paid just $20 a month in an
area where rents typically top $2,000 per
month. His unit was so dilapidated that his
roof collapsed. But he stayed put, which
turned out to be a profitable decision: after
three years of negotiations with the landlord, he was paid $2.5 million to vacate the
apartment. As Agarwal says, “For generations, most tenants were living a hand-tomouth existence, barely making two ends
Mumbai’s Rent-Control Millionaires
In Mumbai, soaring property values have
made multimillionaires of some, although
many more Indians live in slums.
people were killed when four floors of a
rent-controlled apartment building collapsed. Despite demands by the city to
vacate the damaged building, 58 tenants
camped out, refusing to go even though
they were locked out of their apartments,
and were subjects of a police raid.
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CHAPTER 4
Rent control began in Mumbai in 1947
to address a crucial shortage of housing
caused by a flood of refugees fleeing
conflict between Hindus and Muslims.
Clearly intended as a temporary measure, it was so popular politically that it
has been extended 20 times and now
applies to about 60% of the buildings
in the city’s center. Tenants pass apartments on to heirs or sell the right to
occupy to others. Landlords, who often
are paying more in taxes and upkeep
than they receive in rents, suffer financially and sometimes simply abandon
their properties.
So although it’s a world away, the
dynamics of rent control in Mumbai are
similar to those in New York where many
rent-controlled tenants have also extracted
tens of thousands of dollars from landlords eager to redevelop their properties
(although the situation in Mumbai has
been much more extreme).
So common is the experience in New
York and other cities that it was the
subject of a Law and Order episode in
which a landlord is investigated for the
murder of a rent-controlled tenant who
had been blocking the lucrative sale of
the building. Fortunately, we were unable
to find evidence to suggest that this episode was based on a true story.
•
hazardous to inhabit. As one former manager of Manhattan buildings described:
“At unregulated apartments we’d do most things that the tenants requested. But
on the rent-regulated units, we did absolutely only what the law required. . . . We
had a perverse incentive to make those tenants unhappy.”
This whole situation is a missed opportunity—some tenants would be happy
to pay for better conditions, and landlords would be happy to provide them for
payment. But such an exchange would occur only if the market were allowed to
operate freely.
Black Markets In addition to these four inefficiencies there is a final aspect
of price ceilings: the incentive they provide for illegal activities, specifically
the emergence of black markets. We have already described one kind of black
market activity—illegal subletting by tenants. But it does not stop there. Clearly,
there is a temptation for a landlord to say to a potential tenant, “Look, you can
have the place if you slip me an extra few hundred in cash each month”—and
for the tenant to agree if he or she is one of those people who would be willing
to pay much more than the maximum legal rent.
What’s wrong with black markets? In general, it’s a bad thing if people break
any law, because it encourages disrespect for the law in general. Worse yet, in
this case illegal activity worsens the position of those who are honest. If the Lees
are scrupulous about upholding the rent-control law but other people—who may
need an apartment less than the Lees—are willing to bribe landlords, the Lees
may never find an apartment.
A black market is a market in which
goods or services are bought and
sold illegally—either because it is
illegal to sell them at all or because
the prices charged are legally
prohibited by a price ceiling.
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So Why Are There Price Ceilings?
We have seen three common results of price ceilings:
• A persistent shortage of the good
• Inefficiency arising from this persistent shortage in the form of inefficiently
low quantity transacted, inefficient allocation of the good to consumers,
resources wasted in searching for the good, and the inefficiently low quality
of the good offered for sale
• The emergence of illegal, black market activity
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Given these unpleasant consequences of price ceilings, why do governments still
sometimes impose them? Why does rent control, in particular, persist in New York?
One answer is that although price ceilings may have adverse effects, they do
benefit some people. In practice, New York’s rent-control rules—which are more
complex than our simple model—hurt most residents but give a small minority
of renters much cheaper housing than they would get in an unregulated market.
And those who benefit from the controls are typically better organized and more
vocal than those who are harmed by them.
Also, when price ceilings have been in effect for a long time, buyers may
not have a realistic idea of what would happen without them. In our previous
example, the rental rate in an unregulated market (Figure 4-1) would be only
25% higher than in the regulated market (Figure 4-2): $1,000 instead of $800.
But how would renters know that? Indeed, they might have heard about black
market transactions at much higher prices—the Lees or some other family
paying George $1,200 or more—and would not realize that these black market
prices are much higher than the price that would prevail in a fully unregulated market.
A last answer is that government officials often do not understand supply and
demand analysis! It is a great mistake to suppose that economic policies in the
real world are always sensible or well informed.
Price Controls in Venezuela:
“You Buy What They Have”
Reuters/Daniel Aguilar/Landov
B
Venezuela’s food shortages offer a
lesson in why price ceilings, however
well intentioned, are usually never a
good idea.
y all accounts, Venezuela is a rich country—one of
the world’s top oil producers in a time of high energy
prices. But in late 2013, the chronic lack of basic
items—toilet paper, rice, coffee, corn, flour, milk, meat—had
hit a nerve. “Empty shelves and no one to explain why a rich
country has no food. It’s unacceptable,” said Jesús López, a
90-year-old farmer.
The origins of Venezuela’s food shortages can be traced
to the policies put in place by former Venezuelan president
Hugo Chávez and continued by his successor, Nicolás Maduro.
Chávez came to power in 1998 on a platform denouncing the
country’s economic elite and promising policies that favored
the poor and working class, including price controls on basic
foodstuffs. These price controls led to shortages that began in 2003 and became
severe by 2006. Prices were set so low that farmers reduced production. For
example, Venezuela was a coffee exporter until 2009 when it was forced to import
large amounts of coffee to make up for a steep fall in production. Venezuela now
imports more than 70% of its food.
In addition, generous government programs for the poor and working class
led to higher demand. The combination of price controls and higher demand led
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to sharply rising prices for goods that weren’t subject to price controls or that
were bought on the black market. The result was a big increase in the demand for
price-controlled goods.
Worse yet, a sharp decline in the value of the Venezuelan currency made foreign
imports more expensive. And it increased the incentives for smuggling: when goods
are available at the government-mandated price, Venezuelans buy them and then resell
across the border in Colombia, where a bottle of milk is worth seven or eight times
more. Not surprisingly, fresh milk and butter are rarely seen in Venezuelan markets.
Venezuelans, queuing for hours to purchase goods at state-run stores, often
come away empty handed. Or, as one shopper, Katherine Huga, said, “Whatever
I can get. You buy what they have.” While items can often be found on the black
market at much higher prices, Chávez’s price-control policies have disproportionately hurt the lower- and middle-income consumers he sought to help. One shopper in a low-income area who waited in line for hours said, “It fills me with rage
to have to spend the one free day I have wasting my time for a bag of rice. I end up
paying more at the resellers. In the end, all these price controls proved useless.”
Check Your Understanding
4-1
111
Quick Review
• Price controls take the form
of either legal maximum prices—
price ceilings—or legal minimum
prices—price floors.
• A price ceiling below the
equilibrium price benefits
successful buyers but causes
predictable adverse effects such
as persistent shortages, which
lead to four types of inefficiencies:
inefficiently low quantity
transacted, inefficient allocation
to consumers, wasted resources,
and inefficiently low quality.
• Price ceilings also lead to
1. On game days, homeowners near Middletown University’s stadium used to rent
parking spaces in their driveways to fans at a going rate of $11. A new town ordinance now sets a maximum parking fee of $7. Use the accompanying supply and
demand diagram to explain how each of the following corresponds to a priceceiling concept.
a. Some homeowners now think it’s not worth the hassle to rent out spaces.
b. Some fans who used to carpool to the game now drive alone.
c. Some fans can’t find parking and leave without seeing
the game.
Parking fee
Explain how each of the following adverse effects arises
$15
from the price ceiling.
d. Some fans now arrive several hours early to find park11
ing.
e. Friends of homeowners near the stadium regularly attend
7
games, even if they aren’t big fans. But some serious fans
have given up because of the parking situation.
3
f. Some homeowners rent spaces for more than $7 but
pretend that the buyers are nonpaying friends or family.
2. True or false? Explain your answer. A price ceiling below
the equilibrium price of an otherwise efficient market does
the following:
a. Increases quantity supplied
b. Makes some people who want to consume the good worse off
c. Makes all producers worse off
0
3,200
black markets, as buyers and
sellers attempt to evade the price
controls.
S
E
D
3,600
4,000
4,400
4,800
Quantity of parking spaces
Solutions appear at back of book.
Price Floors
Sometimes governments intervene to push market prices up instead of down. Price
floors have been widely legislated for agricultural products, such as wheat and
milk, as a way to support the incomes of farmers. Historically, there were also price
floors—legally mandated minimum prices—on such services as trucking and air
travel, although these were phased out by the U.S. government in the 1970s.
If you have ever worked in a fast-food restaurant, you are likely to have
encountered a price floor: governments in the United States and many other
countries maintain a lower limit on the hourly wage rate of a worker’s labor; that
is, a floor on the price of labor called the minimum wage.
The minimum wage is a legal
floor on the wage rate, which is the
market price of labor.
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FIGURE 4-4
The Market for Butter in the Absence of Government Controls
Price
of butter
(per pound)
Quantity of butter
S
$1.40
1.30
1.20
1.10
E
1.00
0.90
0.80
0.70
0.60
0
(millions of pounds)
Price of butter
(per pound)
Quantity
demanded
Quantity
supplied
$1.40
$1.30
$1.20
$1.10
$1.00
$0.90
$0.80
$0.70
$0.60
8.0
8.5
9.0
9.5
10.0
10.5
11.0
11.5
12.0
14.0
13.0
12.0
11.0
10.0
9.0
8.0
7.0
6.0
D
6
7
8
9 10 11 12 13 14
Quantity of butter (millions of pounds)
Without government intervention, the market for butter reaches equilibrium at a price of $1 per pound with
10 million pounds of butter bought and sold.
Just like price ceilings, price floors are intended to help some people but generate
predictable and undesirable side effects. Figure 4-4 shows hypothetical supply and
demand curves for butter. Left to itself, the market would move to equilibrium at
point E, with 10 million pounds of butter bought and sold at a price of $1 per pound.
Now suppose that the government, in order to help dairy farmers, imposes
a price floor on butter of $1.20 per pound. Its effects are shown in Figure 4-5,
where the line at $1.20 represents the price floor. At a price of $1.20 per pound,
producers would want to supply 12 million pounds (point B on the supply
curve) but consumers would want to buy only 9 million pounds (point A on
the demand curve). So the price floor leads to a persistent surplus of 3 million
pounds of butter.
Does a price floor always lead to an unwanted surplus? No. Just as in the case
of a price ceiling, the floor may not be binding—that is, it may be irrelevant. If
the equilibrium price of butter is $1 per pound but the floor is set at only $0.80,
the floor has no effect.
But suppose that a price floor is binding: what happens to the unwanted
surplus? The answer depends on government policy. In the case of agricultural
price floors, governments buy up unwanted surplus. As a result, the U.S. government has at times found itself warehousing thousands of tons of butter,
cheese, and other farm products. (The European Commission, which administers price floors for a number of European countries, once found itself the
owner of a so-called butter mountain, equal in weight to the entire population of Austria.) The government then has to find a way to dispose of these
unwanted goods.
Some countries pay exporters to sell products at a loss overseas; this is standard
procedure for the European Union. The United States gives surplus food away to
citizens in need as well as to schools, which use the products in school lunches. In
some cases, governments have actually destroyed the surplus production.
CHAPTER 4
FIGURE 4-5
P R I C E C O N T R O L S A N D Q U O TA S : M E D D L I N G W I T H M A R K E T S
The Effects of a Price Floor
The black horizontal line represents
the government-imposed price floor
of $1.20 per pound of butter. The
quantity of butter demanded falls to
9 million pounds, and the quantity
supplied rises to 12 million pounds,
generating a persistent surplus of
3 million pounds of butter.
Price
of butter
(per pound)
Butter surplus of
3 million pounds
caused by price floor
$1.40
1.20
A
B
E
1.00
S
Price
floor
0.80
0.60
0
D
6
8
9 10
12
14
Quantity of butter (millions of pounds)
When the government is not prepared to purchase the unwanted surplus, a
price floor means that would-be sellers cannot find buyers. This is what happens
when there is a price floor on the wage rate paid for an hour of labor, the minimum wage: when the minimum wage is above the equilibrium wage rate, some
people who are willing to work—that is, sell labor—cannot find buyers—that is,
employers—willing to give them jobs.
How a Price Floor Causes Inefficiency
The persistent surplus that results from a price floor creates missed
opportunities—inefficiencies—that resemble those created by the shortage
that results from a price ceiling. Like a price ceiling, a price floor creates
inefficiency in at least four ways:
1. It causes inefficiently low quantity.
2. It leads to an inefficient allocation of sales among sellers.
3. It leads to a waste of resources.
4. It leads to sellers providing an inefficiently high-quality level.
In addition to inefficiency, like a price ceiling, a price floor leads to illegal behavior as people break the law to sell below the legal price.
Inefficiently Low Quantity Because a price floor raises the price of a good to
consumers, it reduces the quantity of that good demanded; because sellers can’t
sell more units of a good than buyers are willing to buy, a price floor reduces the
quantity of a good bought and sold below the market equilibrium quantity. Notice
that this is the same effect as a price ceiling. You might be tempted to think that
a price floor and a price ceiling have opposite effects, but both have the effect of
reducing the quantity of a good bought and sold (as you can see in the accompanying Pitfalls).
As in the case of a price ceiling, the low quantity sold is an inefficiency
due to missed opportunities: price floors prevent mutually beneficial transactions from occurring, transactions that would benefit both buyers and sellers.
113
114 P A R T 2
S U P P LY A N D D E M A N D
A Price Floor Causes Inefficiently Low Quantity
FIGURE 4-6
A price floor reduces the quantity
demanded below the market
equilibrium quantity. Because sellers
can’t sell more units of a good than
buyers are willing to buy, a price
floor reduces the quantity of a good
bought and sold.
Price
of butter
(per pound)
S
$1.40
1.20
Price
floor
E
1.00
0.80
0.60
0
D
6
8
9
Quantity
demanded with
price floor
10
12
14
Quantity of
Quantity
butter
demanded without (millions of
price floor
pounds)
Figure 4-6 shows the inefficiently low quantity of butter sold with a price floor
on the price of butter.
Inefficient Allocation of Sales Among Sellers Like a price ceiling, a price
Price floors can lead to inefficient
allocation of sales among
sellers: sellers who are willing to
sell at the lowest price are unable
to make sales while sales go to
sellers who are only willing to sell at
a higher price.
floor can lead to inefficient allocation—in this case, an inefficient allocation
of sales among sellers: sellers who are willing to sell at the lowest price are
unable to make sales, while sales go to sellers who are only willing to sell at a
higher price.
One illustration of the inefficient allocation of selling opportunities caused
by a price floor is the problem of unemployment and the black market for labor
among the young in many European countries—notably France, Spain, Italy,
and Greece. In these countries, a high minimum wage has led to a two-tier labor
system, composed of the fortunate who have good jobs in the formal labor market that pay at least the minimum wage, and the rest who are locked out without
any prospect of ever finding a good job. Either unemployed or underemployed in
dead-end jobs in the black market for labor, the unlucky ones are disproportionately young, from the ages of 18 to early 30s.
P I T FA L L S
CEILINGS, FLOORS, AND
QUANTITIES
A price ceiling pushes the price of a
good down. A price floor pushes the
price of a good up. So it’s easy to
assume that the effects of a price floor
are the opposite of the effects of a price
ceiling. In particular, if a price ceiling
reduces the quantity of a good bought
and sold, doesn’t a price floor increase
the quantity?
No, it doesn’t. In fact, both floors
and ceilings reduce the quantity bought
and sold. Why? When the quantity of a
good supplied isn’t equal to the quantity
demanded, the actual quantity sold is
determined by the “short side” of the
market—whichever quantity is less. If
sellers don’t want to sell as much as
buyers want to buy, it’s the sellers who
determine the actual quantity sold,
because buyers can’t force unwilling
sellers to sell. If buyers don’t want to
buy as much as sellers want to sell, it’s
the buyers who determine the actual
quantity sold, because sellers can’t force
unwilling buyers to buy.
CHAPTER 4
P R I C E C O N T R O L S A N D Q U O TA S : M E D D L I N G W I T H M A R K E T S
Although eager for good jobs in the formal sector and willing to accept less
than the minimum wage—that is, willing to sell their labor for a lower price—it
is illegal for employers to pay them less than the minimum wage. The inefficiency
of unemployment and underemployment is compounded as a generation of young
people is unable to get adequate job training, develop careers, and save for their
future. These young people are also more likely to engage in crime. And many of
these countries have seen their best and brightest young people emigrate, leading
to a permanent reduction in the future performance of their economies.
Wasted Resources Also like a price ceiling, a price floor generates inefficiency by
wasting resources. The most graphic examples involve government purchases of the
unwanted surpluses of agricultural products caused by price floors. The surplus production is sometimes destroyed, which is pure waste; in other cases, the stored produce
goes, as officials euphemistically put it, “out of condition” and must be thrown away.
Price floors also lead to wasted time and effort. Consider the minimum wage.
Would-be workers who spend many hours searching for jobs, or waiting in line in
the hope of getting jobs, play the same role in the case of price floors as hapless
families searching for apartments in the case of price ceilings.
Inefficiently High Quality Again like price ceilings, price floors lead to inefficiency in the quality of goods produced.
We saw that when there is a price ceiling, suppliers produce products that are
of inefficiently low quality: buyers prefer higher-quality products and are willing to
pay for them, but sellers refuse to improve the quality of their products because the
price ceiling prevents their being compensated for doing so. This same logic applies
to price floors, but in reverse: suppliers offer goods of inefficiently high quality.
How can this be? Isn’t high quality a good thing? Yes, but only if it is worth
the cost. Suppose that suppliers spend a lot to make goods of very high quality
but that this quality isn’t worth much to consumers, who would rather receive the
money spent on that quality in the form of a lower price. This represents a missed
opportunity: suppliers and buyers could make a mutually beneficial deal in which
buyers got goods of lower quality for a much lower price.
A good example of the inefficiency of excessive quality comes from the days
when transatlantic airfares were set artificially high by international treaty.
Forbidden to compete for customers by offering lower ticket prices, airlines
instead offered expensive services, like lavish in-flight meals that went largely
uneaten. At one point the regulators tried to restrict this practice by defining
maximum service standards—for example, that snack service should consist of no more than a sandwich. One airline then introduced what it called a
“Scandinavian Sandwich,” a towering affair that forced the convening of another
conference to define sandwich. All of this was wasteful, especially considering
that what passengers really wanted was less food and lower airfares.
Since the deregulation of U.S. airlines in the 1970s, American passengers
have experienced a large decrease in ticket prices accompanied by a decrease
in the quality of in-flight service—smaller seats, lower-quality food, and so on.
Everyone complains about the service—but thanks to lower fares, the number of
people flying on U.S. carriers has grown from 130 billion passenger miles when
deregulation began to approximately 900 billion in 2014.
Illegal Activity In addition to the four inefficiencies we analyzed, like price
ceilings, price floors provide incentives for illegal activity. For example, in
countries where the minimum wage is far above the equilibrium wage rate,
workers desperate for jobs sometimes agree to work off the books for employers
who conceal their employment from the government—or bribe the government
inspectors. This practice, known in Europe as “black labor,” is especially common in Southern European countries such as Italy and Spain.
115
Price floors often lead to inefficiency
in that goods of inefficiently high
quality are offered: sellers offer
high-quality goods at a high price,
even though buyers would prefer a
lower quality at a lower price.
116 P A R T 2
S U P P LY A N D D E M A N D
GLOBAL
COMPARISION
Check Out Our Low, Low Wages!
T
he minimum wage rate in the United States, as you can
see in this graph, is actually quite low compared with
that in other rich countries. Since minimum wages are set in
national currency—the British minimum wage is set in British
pounds, the French minimum wage is set in euros, and so
on—the comparison depends on the exchange rate on any
given day. As of 2013, Australia had a minimum wage over
twice as high as the U.S. rate, with France, Canada, and
Ireland not far behind. You can see one effect of this difference in the supermarket checkout line. In the United States
there is usually someone to bag your groceries—someone
typically paid the minimum wage or at best slightly more. In
Europe, where hiring a bagger is a lot more expensive, you’re
almost always expected to do the bagging yourself.
Australia
A$15.74 = US$16.00
€9.31 = US$11.70
France
Ireland
€8.65 = US$10.90
Canada
C$11.00* = US$10.79
Britain
£6.11 = US$9.40
United
States
$7.25
0
2
4
6
8
10 12 14 $16
Minimum wage (per hour)
Source: Organization for Economic Cooperation and Development (OECD).
*The Canadian minimum wage varies by province from C$9.95 to C$11.00.
So Why Are There Price Floors?
To sum up, a price floor creates various negative side effects:
• A persistent surplus of the good
• Inefficiency arising from the persistent surplus in the form of inefficiently
low quantity transacted, inefficient allocation of sales among sellers, wasted
resources, and an inefficiently high level of quality offered by suppliers
• The temptation to engage in illegal activity, particularly bribery and corruption of government officials
So why do governments impose price floors when they have so many negative side
effects? The reasons are similar to those for imposing price ceilings. Government officials often disregard warnings about the consequences of price floors either because
they believe that the relevant market is poorly described by the supply and demand
model or, more often, because they do not understand the model. Above all, just as
price ceilings are often imposed because they benefit some influential buyers of a
good, price floors are often imposed because they benefit some influential sellers.
s
ECONOMICS
in Action
The Rise and Fall of the Unpaid Intern
T
he best-known example of a price floor is the minimum wage. Most economists believe, however, that the minimum wage has relatively little effect
on the overall job market in the United States, mainly because the floor is
set so low. In 1964, the U.S. minimum wage was 53% of the average wage of bluecollar production workers; by 2013, it had fallen to about 37%. However, there is
one sector of the U.S. job market where it appears that the minimum wage can
indeed be binding: the market for interns.
Internships are temporary work positions typically reserved for younger
workers still in college or recent graduates. The sluggish U.S. economy of recent
years has produced poor job prospects for workers 20 to 24 years old. The unemployment rate for this age group was almost 12% at the start of 2014. One result
of this has been a rise in the availability of internships, which look increasingly
appealing to enthusiastic young workers unable to find well-paid permanent jobs.
P R I C E C O N T R O L S A N D Q U O TA S : M E D D L I N G W I T H M A R K E T S
117
Internships fall into two broad categories: paid interns, who are
formally hired as temporary workers, and must be paid at least the
minimum wage, and unpaid interns, who perform tasks but are not
legally designated employees and aren’t covered by minimum wage
laws. Because internships offer the promise of valuable work experience and credentials that can later prove very valuable, young workers are often willing to accept them at a low wage or even no wage.
According to Robert Shindell, an executive at the consulting firm
Intern Bridge, more than a million American students a year do internships; a fifth of those positions pay zero and provide no course credits.
Not surprisingly, some companies are tempted to use unpaid
interns to perform work that in reality has little or no educational
value but that directly benefits the company.
To guard against such practices, the Department of Labor (DOL),
the federal agency that monitors compliance with minimum wage
laws, issued several criteria in 2010 to help companies determine
“We have an opening for a part-time upaid intern,
whether their unpaid internships are legally exempt from minimum
which could lead to a full-time unpaid internship.”
wage requirements. Among them are: (1) Is the experience primarily
for the benefit of the intern and not the employer? (2) Is the internship comparable to training offered by an educational environment? and (3) Is there no displacement of a regular employee by the intern? If the answer to such questions
is yes, then the DOL considers the internship to be a form of education that is
exempt from minimum wage laws. However, if the answer to any of the questions
is no, then the DOL may determine that the unpaid internship violates minimum
wage laws, in which case, the position must either be converted into a paid internQuick Review
ship that pays at least the minimum wage or be eliminated.
• The most familiar price floor is
In 2012 and 2013, a spate of lawsuits brought by former unpaid interns claimthe minimum wage. Price floors
ing they were cheated out of wages brought the matter to public attention. In
are also commonly imposed on
2013, the movie company Fox Searchlight Pictures was found guilty of breaking
agricultural goods.
federal minimum wage laws for employing two interns at zero pay. A common
• A price floor above the
thread in these complaints is that interns were assigned “grunt work” that had
equilibrium price benefits
no educational value—such as tracking lost cell phones. In some cases, unpaid
successful sellers but causes
predictable adverse effects such as
interns complained that they were given the work of full-salaried employees.
a persistent surplus, which leads
As a result, many lawyers who advise companies on labor laws have been
to four kinds of inefficiencies:
advising companies to either pay their interns minimum wage or shut down their
inefficiently low quantity
internships. While some have axed their programs altogether, others—such as Fox
transacted, inefficient allocation
Searchlight and NBC News—have converted their unpaid internships to paid ones.
of sales among sellers, wasted
Some observers worry that the end of the unpaid internships means that programs
resources, and inefficiently high
that once offered valuable training will be lost. But as one lawyer commented, “The
quality.
law says that when you work, you have to get paid [at least the minimum wage].”
• Price floors encourage illegal
Check Your Understanding
activity, such as workers who
work off the books, often leading
to official corruption.
4-2
1. The state legislature mandates a price floor for gasoline of
PF per gallon. Assess the following statements and illustrate your
answer using the figure provided.
a. Proponents of the law claim it will increase the income of gas
station owners. Opponents claim it will hurt gas station owners because they will lose customers.
b. Proponents claim consumers will be better off because gas
stations will provide better service. Opponents claim consumers will be generally worse off because they prefer to buy gas
at cheaper prices.
c. Proponents claim that they are helping gas station owners
without hurting anyone else. Opponents claim that consumers are hurt and will end up doing things like buying gas in a
nearby state or on the black market.
Solutions appear at back of book.
Price of gas
PF
A
B
S
Price
floor
E
PE
D
QF
QE
Quantity of gas
Aaron Bacall/www.Cartoonstock.com
CHAPTER 4
118 P A R T 2
S U P P LY A N D D E M A N D
A quantity control, or quota, is
an upper limit on the quantity of
some good that can be bought or
sold. The total amount of the good
that can be legally transacted is the
quota limit.
A license gives its owner the right
to supply a good.
Controlling Quantities
In the 1930s, New York City instituted a system of licensing for taxicabs: only
taxis with a “medallion” were allowed to pick up passengers. Because this system
was intended to assure quality, medallion owners were supposed to maintain
certain standards, including safety and cleanliness. A total of 11,787 medallions
were issued, with taxi owners paying $10 for each medallion.
In 1995, there were still only 11,787 licensed taxicabs in New York, even
though the city had meanwhile become the financial capital of the world, a place
where hundreds of thousands of people in a hurry tried to hail a cab every day.
An additional 400 medallions were issued in 1995, and after several rounds of
sales of additional medallions, today there are 15,000 medallions. The result of
this restriction is that a New York city taxi medallion is a very valuable item: if
you want to to operate a tax in the city, you must lease a medallion from someone
else or buy one, with a current price today of over a million dollars.
It turns out that this story is not unique; other cities introduced similar
medallion systems in the 1930s and, like New York, have issued few new medallions since. In San Francisco and Boston, as in New York, taxi medallions trade
for seven-figure prices.
A taxi medallion system is a form of quantity control, or quota, by which the
government regulates the quantity of a good that can be bought and sold rather
than the price at which it is transacted. It is another way that government intervenes in markets along with price ceilings and price floors. The total amount of
the good that can be transacted under the quantity control is called the quota
limit. Typically, the government limits quantity in a market by issuing licenses;
only people with a license can legally supply the good.
A taxi medallion is just such a license. The government of New York City limits the number of taxi rides that can be sold by limiting the number of taxis to
only those who hold medallions. There are many other cases of quantity controls,
ranging from limits on how much foreign currency (for instance, British pounds
or Mexican pesos) people are allowed to buy to the quantity of clams New Jersey
fishing boats are allowed to catch.
In the real world, quantity controls set an upper limit on the quantity of a
good that can be transacted. Some attempts to control quantities are undertaken
for good economic reasons, some for bad ones. In many cases, as we will see,
quantity controls introduced to address a temporary problem become politically
hard to remove later because the beneficiaries don’t want them abolished, even
after the original reason for their existence is long gone. But whatever the reasons for such controls, they have certain predictable—and usually undesirable—
economic consequences.
The Anatomy of Quantity Controls
To understand why a New York taxi medallion is worth so much money, we consider a simplified version of the market for taxi rides, shown in Figure 4-7. Just as
we assumed in the analysis of rent control that all apartments are the same, we
now suppose that all taxi rides are the same—ignoring the real-world complication that some taxi rides are longer, and so more expensive, than others.
The table in the figure shows supply and demand schedules. The equilibrium—
indicated by point E in the figure and by the shaded entries in the table—is a fare
of $5 per ride, with 10 million rides taken per year. (You’ll see in a minute why
we present the equilibrium this way.)
The New York medallion system limits the number of taxis, but each taxi
driver can offer as many rides as he or she can manage. (Now you know why New
York taxi drivers are so aggressive!) To simplify our analysis, however, we will
assume that a medallion system limits the number of taxi rides that can legally
be given to 8 million per year.
CHAPTER 4
FIGURE 4-7
P R I C E C O N T R O L S A N D Q U O TA S : M E D D L I N G W I T H M A R K E T S
The Market for Taxi Rides in the Absence of Government Controls
Fare
(per ride)
Quantity of rides
S
$7.00
6.50
6.00
5.50
5.00
4.50
4.00
3.50
3.00
0
119
E
D
6
7
(millions per year)
Fare
(per ride)
Quantity
demanded
Quantity
supplied
$7.00
$6.50
$6.00
$5.50
$5.00
$4.50
$4.00
$3.50
$3.00
6
7
8
9
10
11
12
13
14
14
13
12
11
10
9
8
7
6
8
9 10 11 12 13 14
Quantity of rides (millions per year)
Without government intervention, the market reaches equilibrium with 10 million rides taken per year
at a fare of $5 per ride.
Until now, we have derived the demand curve by answering questions of the
form: “How many taxi rides will passengers want to take if the price is $5 per
ride?” But it is possible to reverse the question and ask instead: “At what price will
consumers want to buy 10 million rides per year?” The price at which consumers
want to buy a given quantity—in this case, 10 million rides at $5 per ride—is
the demand price of that quantity. You can see from the demand schedule in
Figure 4-7 that the demand price of 6 million rides is $7 per ride, the demand
price of 7 million rides is $6.50 per ride, and so on.
Similarly, the supply curve represents the answer to questions of the form:
“How many taxi rides would taxi drivers supply at a price of $5 each?” But we
can also reverse this question to ask: “At what price will suppliers be willing to
supply 10 million rides per year?” The price at which suppliers will supply a given
quantity—in this case, 10 million rides at $5 per ride—is the supply price of that
quantity. We can see from the supply schedule in Figure 4-7 that the supply price
of 6 million rides is $3 per ride, the supply price of 7 million rides is $3.50 per
ride, and so on.
Now we are ready to analyze a quota. We have assumed that the city government limits the quantity of taxi rides to 8 million per year. Medallions, each of
which carries the right to provide a certain number of taxi rides per year, are
made available to selected people in such a way that a total of 8 million rides will
be provided. Medallion-holders may then either drive their own taxis or rent their
medallions to others for a fee.
Figure 4-8 shows the resulting market for taxi rides, with the black vertical line
at 8 million rides per year representing the quota limit. Because the quantity of
rides is limited to 8 million, consumers must be at point A on the demand curve,
corresponding to the shaded entry in the demand schedule: the demand price of
8 million rides is $6 per ride. Meanwhile, taxi drivers must be at point B on the
supply curve, corresponding to the shaded entry in the supply schedule: the supply
price of 8 million rides is $4 per ride.
But how can the price received by taxi drivers be $4 when the price paid by
taxi riders is $6? The answer is that in addition to the market in taxi rides, there
The demand price of a given
quantity is the price at which
consumers will demand that quantity.
The supply price of a given quantity
is the price at which producers will
supply that quantity.
120 P A R T 2
S U P P LY A N D D E M A N D
FIGURE 4-8
Effect of a Quota on the Market for Taxi Rides
Fare
(per ride)
$7.00
6.50
6.00
5.50
5.00
4.50
4.00
3.50
3.00
Quantity of rides
(millions per year)
S
A
The
“wedge”
E
B
D
Quota
0
6
7
(per ride)
Fare
Quantity
demanded
Quantity
supplied
$7.00
$6.50
$6.00
$5.50
$5.00
$4.50
$4.00
$3.50
$3.00
6
7
8
9
10
11
12
13
14
14
13
12
11
10
9
8
7
6
8
9 10 11 12 13 14
Quantity of rides (millions per year)
The table shows the demand price and the supply price
corresponding to each quantity: the price at which that
quantity would be demanded and supplied, respectively. The
city government imposes a quota of 8 million rides by selling
licenses for only 8 million rides, represented by the black
vertical line. The price paid by consumers rises to $6 per
ride, the demand price of 8 million rides, shown by
point A. The supply price of 8 million rides is only $4 per
ride, shown by point B. The difference between these two
prices is the quota rent per ride, the earnings that accrue
to the owner of a license. The quota rent drives a wedge
between the demand price and the supply price and
discourages mutually beneficial transactions.
is also a market in medallions. Medallion-holders may not always want to drive
their taxis: they may be ill or on vacation. Those who do not want to drive their
own taxis will sell the right to use the medallion to someone else.
So we need to consider two sets of transactions here, and so two prices: (1)
the transactions in taxi rides and the price at which these will occur, and (2) the
transactions in medallions and the price at which these will occur. It turns out
that since we are looking at two markets, the $4 and $6 prices will both be right.
To see how this all works, consider two imaginary New York taxi drivers, Sunil
and Harriet. Sunil has a medallion but can’t use it because he’s recovering from a
severely sprained wrist. So he’s looking to rent his medallion out to someone else.
Harriet doesn’t have a medallion but would like to rent one. Furthermore, at any
point in time there are many other people like Harriet who would like to rent a
medallion. Suppose Sunil agrees to rent his medallion to Harriet. To make things
simple, assume that any driver can give only one ride per day and that Sunil is
renting his medallion to Harriet for one day. What rental price will they agree on?
To answer this question, we need to look at the transactions from the viewpoints of both drivers. Once she has the medallion, Harriet knows she can make
$6 per day—the demand price of a ride under the quota. And she is willing to rent
the medallion only if she makes at least $4 per day—the supply price of a ride
under the quota. So Sunil cannot demand a rent of more than $2—the difference
between $6 and $4. And if Harriet offered Sunil less than $2—say, $1.50—there
would be other eager drivers willing to offer him more, up to $2. So, in order to
get the medallion, Harriet must offer Sunil at least $2. Since the rent can be no
more than $2 and no less than $2, it must be exactly $2.
CHAPTER 4
P R I C E C O N T R O L S A N D Q U O TA S : M E D D L I N G W I T H M A R K E T S
It is no coincidence that $2 is exactly the difference between $6, the demand price
of 8 million rides, and $4, the supply price of 8 million rides. In every case in which
the supply of a good is legally restricted, there is a wedge between the demand price
of the quantity transacted and the supply price of the quantity transacted.
This wedge, illustrated by the double-headed arrow in Figure 4-8, has a special
name: the quota rent. It is the earnings that accrue to the license-holder from
ownership of a valuable commodity, the license. In the case of Sunil and Harriet,
the quota rent of $2 goes to Sunil because he owns the license, and the remaining
$4 from the total fare of $6 goes to Harriet.
So Figure 4-8 also illustrates the quota rent in the market for New York taxi
rides. The quota limits the quantity of rides to 8 million per year, a quantity at
which the demand price of $6 exceeds the supply price of $4. The wedge between
these two prices, $2, is the quota rent that results from the restrictions placed on
the quantity of taxi rides in this market.
But wait a second. What if Sunil doesn’t rent out his medallion? What if he
uses it himself? Doesn’t this mean that he gets a price of $6? No, not really. Even
if Sunil doesn’t rent out his medallion, he could have rented it out, which means
that the medallion has an opportunity cost of $2: if Sunil decides to use his own
medallion and drive his own taxi rather than renting his medallion to Harriet, the
$2 represents his opportunity cost of not renting out his medallion. That is, the $2
quota rent is now the rental income he forgoes by driving his own taxi.
In effect, Sunil is in two businesses—the taxi-driving business and the
medallion-renting business. He makes $4 per ride from driving his taxi and $2
per ride from renting out his medallion. It doesn’t make any difference that in this
particular case he has rented his medallion to himself!
So regardless of whether the medallion owner uses the medallion himself
or herself, or rents it to others, it is a valuable asset. And this is represented in
the going price for a New York City taxi medallion: in 2013, New York City taxi
medallions sold for $1 to $1.2 million. According to Simon Greenbaum, a broker
of New York taxi medallions, an owner of a medallion who leases it to a driver
can expect to earn about $2,500 per month, or a 3% return—an attractive rate of
return compared to other investments.
Notice, by the way, that quotas—like price ceilings and price floors—don’t
always have a real effect. If the quota were set at 12 million rides—that is, above
the equilibrium quantity in an unregulated market—it would have no effect
because it would not be binding.
The Costs of Quantity Controls
Like price controls, quantity controls can have some predictable and undesirable
side effects. The first is the by-now-familiar problem of inefficiency due to missed
opportunities: quantity controls prevent mutually beneficial transactions from
occurring, transactions that would benefit both buyers and sellers. Looking back
at Figure 4-8, you can see that starting at the quota limit of 8 million rides, New
Yorkers would be willing to pay at least $5.50 per ride when 9 million rides are
offered, 1 million more than the quota, and that taxi drivers would be willing to
provide those rides as long as they got at least $4.50 per ride. These are rides that
would have taken place if there were no quota limit.
The same is true for the next 1 million rides: New Yorkers would be willing to
pay at least $5 per ride when the quantity of rides is increased from 9 to 10 million, and taxi drivers would be willing to provide those rides as long as they got at
least $5 per ride. Again, these rides would have occurred without the quota limit.
Only when the market has reached the unregulated market equilibrium quantity of 10 million rides are there no “missed-opportunity rides.” The quota limit
of 8 million rides has caused 2 million “missed-opportunity rides.”
121
A quantity control, or quota, drives a
wedge between the demand price
and the supply price of a good; that
is, the price paid by buyers ends up
being higher than that received by
sellers.
The difference between the demand
and supply price at the quota limit
is the quota rent, the earnings that
accrue to the license-holder from
ownership of the right to sell the
good. It is equal to the market price
of the license when the licenses are
traded.
122 P A R T 2
S U P P LY A N D D E M A N D
Generally, as long as the demand price of a given quantity exceeds the supply
price, there is a missed opportunity. A buyer would be willing to buy the good at
a price that the seller would be willing to accept, but such a transaction does not
occur because it is forbidden by the quota.
And because there are transactions that people would like to make but are not
allowed to, quantity controls generate an incentive to evade them or even to break
the law. New York’s taxi industry again provides clear examples. Taxi regulation
applies only to those drivers who are hailed by passengers on the street. A car service that makes prearranged pickups does not need a medallion. As a result, such
hired cars provide much of the service that might otherwise be provided by taxis,
as in other cities. In addition, there are substantial numbers of unlicensed cabs
that simply defy the law by picking up passengers without a medallion. Because
these cabs are illegal, their drivers are completely unregulated, and they generate
a disproportionately large share of traffic accidents in New York City.
In fact, in 2004 the hardships caused by the limited number of New York taxis
led city leaders to authorize an increase in the number of licensed taxis by 900.
The city auctioned off an additional 2,000 medallions in 2013, bringing the total
number up to the current 15,000 medallions—a move that certainly cheered New
York riders.
But those who already owned medallions were less happy with the increase;
they understood that adding new taxis would reduce or eliminate the shortage
of taxis. As a result, taxi drivers anticipated a decline in their revenues because
they would no longer always be assured of finding willing customers. And, in
turn, the value of a medallion would fall. So to placate the medallion owners, city
officials also raised taxi fares: by 25% in 2004, by a smaller percentage in 2006,
and again by about 17% in 2012. Although taxis are now easier to find, a ride now
costs more—and that price increase slightly diminished the newfound cheer of
New York taxi riders.
In sum, quantity controls typically create the following undesirable side effects:
• Inefficiencies, or missed opportunities, in the form of mutually beneficial
transactions don’t occur
• Incentives for illegal activities
s
ECONOMICS
in Action
Crabbing, Quotas, and Saving Lives in Alaska
A
laskan king and snow crab are considered delicacies worldwide. And crab
fishing is one of the most important industries in the Alaskan economy. So
many were justifiably concerned when, in 1983, the annual crab catch fell
by 90% due to overfishing. In response, marine biologists set a total catch quota
system, which limited the amount of crab that could be harvested annually in
order to allow the crab population to return to a healthy, sustainable level.
Notice, by the way, that the Alaskan crab quota is an example of a quota that
was justified by broader economic and environmental considerations—unlike
the New York taxicab quota, which has long since lost any economic rationale.
Another important difference is that, unlike New York taxicab medallions, owners of Alaskan crab boats did not have the ability to buy or sell individual quotas.
So although depleted crab stocks eventually recovered with the total catch quota
system in place, there was another, unintended and deadly consequence.
The Alaskan crabbing season is fairly short, running roughly from October
to January, and it can be further shortened by bad weather. By the 1990s,
Alaskan crab fishermen were engaging in “fishing derbies,” made famous by
the Discovery Channel’s Deadliest Catch. To stay within the quota limit when
P R I C E C O N T R O L S A N D Q U O TA S : M E D D L I N G W I T H M A R K E T S
123
the crabbing season began, boat crews rushed to fish
for crab in dangerous, icy, rough water, straining to
harvest in a few days a haul that could be worth several hundred thousand dollars. As a result, boats often
became overloaded and capsized. Crews were pushed
too hard, with many fatalities from hypothermia or
drowning.
According to federal statistics, at the time Alaskan
crab fishing was among the most dangerous of jobs,
with an average of 7.3 deaths a year, about 80 times the
fatality rate for an average worker. And after the brief
harvest, the market for crab was flooded with supply,
lowering the prices fishermen received.
In 2006 fishery regulators instituted another quota
system called quota share—aimed at protecting crabbers
as well as Alaska’s crabs. Under individual quota share,
each boat received a quota to fill during the three month
The quota-share system protects Alaska’s crab population and
season. Moreover, the individual quotas could be sold or
saves the lives of crabbers.
leased. These changes transformed the industry as owners of bigger boats bought the individual quotas of smaller
boats, shrinking the number of crabbing boats dramatically: from over 250 a few
years earlier to about 60 in 2012. Bigger boats are much less likely to capsize,
improving crew safety.
In addition, by extending the fishing season, the quota-share system boosted
the crab population and crab prices. In 2004, under the old system, the quota
was reached in just 3 days, while in 2010 in took 20 days. With more time to fish,
fishermen could make sure that juvenile and female crabs were returned to sea
rather than harvested. And with a longer fishing season, the catch comes to the
market more gradually, eliminating the downward plunge in prices when supply
hits the market. In 2011, snow crab sold for close to $7 per pound, up from close
to $3 per pound in 2005.
Quick Review
Predictably, an Alaskan crab fisherman earns more money under the quota• Quantity controls, or quotas,
share system than under the total catch quota system. As one observer said in
are government-imposed limits
on how much of a good may
2012, “The information we have on crabbers’ income is anecdotal, but crewmen
be bought or sold. The quantity
we surveyed said they’re making about $100,000 a year and captains twice that.
allowed for sale is the quota
That’s a lot more than a few years ago.”
Check Your Understanding
4-3
1. Suppose that the supply and demand for taxi rides is given by Figure 4-7 but the
quota is set at 6 million rides instead of 8 million. Find the following and indicate
them on Figure 4-7.
a. The price of a ride
b. The quota rent
c. Suppose the quota limit on taxi rides is increased to 9 million. What happens to
the quota rent?
2. Assume that the quota limit is 8 million rides. Suppose demand decreases due to
a decline in tourism. What is the smallest parallel leftward shift in demand that
would result in the quota no longer having an effect on the market? Illustrate your
answer using Figure 4-7.
Solutions appear at back of book.
limit. The government then issues
a license—the right to sell a given
quantity of a good under the
quota.
• When the quota limit is smaller
than the equilibrium quantity
in an unregulated market, the
demand price is higher than the
supply price—there is a wedge
between them at the quota limit.
• This wedge is the quota rent,
the earnings that accrue to the
license-holder from ownership of
the right to sell the good—whether
by actually supplying the good or
by renting the license to someone
else. The market price of a license
equals the quota rent.
• Like price controls, quantity
controls create inefficiencies and
encourage illegal activity.
Gamma-Rapho via Getty Images
CHAPTER 4
BUSINESS
CASE
Medallion Financial: Cruising
Right Along
B
The Photo Works
ack in 1937, before New York City froze its number of taxi medallions,
Andrew Murstein’s immigrant grandfather bought his first one for $10. Over
time, the grandfather accumulated 500 medallions, which he rented to other
drivers. Those 500 taxi medallions became the foundation for Medallion Financial:
the company that would eventually pass to Andrew, its current president.
With a market value of $385 million in late 2013, Medallion Financial has
shifted its major line of business from renting out medallions to financing the
purchase of new ones, lending money to those who want to buy a medallion but
don’t have the sizable amount of cash required to do so. Murstein believes that he
is helping people who, like his Polish immigrant grandfather, want to buy a piece
of the American dream.
Andrew Murstein carefully watches the value of a New York City taxi medallion: the more one costs, the more demand there is for loans from Medallion
Financial, and the more interest the company makes on the loan. A loan from
Medallion Financial is secured by the value of the medallion itself. If the
borrower is unable to repay the loan, Medallion Financial takes possession of his or her medallion and resells it to offset the cost of the
loan default. As of 2013, the value of a medallion has risen faster than
stocks, oil, and gold. Over the past two decades, from 1990 through
2013, the value of a medallion rose 720%, compared to 500% for an
index of stocks.
But medallion prices can fluctuate dramatically, threatening profits. During periods of a very strong economy, such as in 1999 and 2001,
the price of New York taxi medallions fell as drivers found jobs in other
sectors. When the New York economy tanked in the aftermath of 9/11, the price of
a medallion fell to $180,000, its lowest level in 12 years. In 2004, medallion owners
were concerned about the impending sale by the New York City Taxi and Limousine
Commission of an additional 900 medallions. As Peter Hernandez, a worried New
York cabdriver who financed his medallion with a loan from Medallion Financial,
said at the time: “If they pump new taxis into the industry, it devalues my medallion.
It devalues my daily income, too.”
Yet Murstein has always been optimistic that medallions would hold their
value. He believed that a 25% fare increase would offset potential losses in their
value caused by the sale of new medallions. In addition, more medallions would
mean more loans for his company.
As of 2013, Murstein’s optimism had been justified. Because of the financial
crisis of 2007–2009, many New York companies cut back the limousine services
they ordinarily provided to their employees, forcing them to take taxis instead.
As a result, the price of a medallion has nearly doubled, from $550,000 in 2008
to more than a million dollars in 2013. And investors have noticed the value in
Medallion Financial’s line of business: from November 2010 through November
2013, shares of Medallion Financial rose 120%.
QUESTIONS FOR THOUGHT
1. How does Medallion Financial benefit from the restriction on the number of
New York taxi medallions?
2. What will be the effect on Medallion Financial if New York companies resume
widespread use of limousine services for their employees? What is the economic
motivation that prompts companies to offer this perk to their employees? (Note
that it is very difficult and expensive to own a personal car in New York City.)
124
3. Predict the effect on Medallion Financial’s business if New York City eliminates restrictions on the number of taxis. That is, if the quota is removed.
CHAPTER 4
P R I C E C O N T R O L S A N D Q U O TA S : M E D D L I N G W I T H M A R K E T S
125
SUMMARY
1. Even when a market is efficient, governments often
intervene to pursue greater fairness or to please a powerful interest group. Interventions can take the form of
price controls or quantity controls, both of which generate predictable and undesirable side effects consisting of various forms of inefficiency and illegal activity.
2. A price ceiling, a maximum market price below the
equilibrium price, benefits successful buyers but
creates persistent shortages. Because the price is
maintained below the equilibrium price, the quantity
demanded is increased and the quantity supplied is
decreased compared to the equilibrium quantity.
This leads to predictable problems: inefficiently
low quantity transacted, inefficient allocation to
consumers, wasted resources, and inefficiently low
quality. It also encourages illegal activity as people
turn to black markets to get the good. Because of
these problems, price ceilings have generally lost favor
as an economic policy tool. But some governments continue to impose them either because they don’t understand the effects or because the price ceilings benefit
some influential group.
3. A price floor, a minimum market price above the equi-
librium price, benefits successful sellers but creates
persistent surplus. Because the price is maintained
above the equilibrium price, the quantity demanded
is decreased and the quantity supplied is increased
compared to the equilibrium quantity. This leads to
predictable problems: inefficiencies in the form of
inefficiently low quantity transacted, inefficient
allocation of sales among sellers, wasted resources,
and inefficiently high quality. It also encourages
illegal activity and black markets. The most well
known kind of price floor is the minimum wage,
but price floors are also commonly applied to
agricultural products.
4. Quantity controls, or quotas, limit the quantity of a
good that can be bought or sold. The quantity allowed
for sale is the quota limit. The government issues
licenses to individuals, the right to sell a given quantity of the good. The owner of a license earns a quota
rent, earnings that accrue from ownership of the right
to sell the good. It is equal to the difference between
the demand price at the quota limit, what consumers are willing to pay for that quantity, and the supply
price at the quota limit, what suppliers are willing to
accept for that quantity. Economists say that a quota
drives a wedge between the demand price and the
supply price; this wedge is equal to the quota rent.
Quantity controls lead to inefficiencies in the form of
mutually beneficial transactions that do not occur in
addition to encouraging illegal activity.
KEY TERMS
Price controls, p. 104
Price ceiling, p. 104
Price floor, p. 104
Inefficient allocation to consumers,
p. 107
Wasted resources, p. 108
Inefficiently low quality, p. 108
Black market, p. 109
Minimum wage, p. 111
Inefficient allocation of sales among
sellers, p. 114
Inefficiently high quality, p. 115
Quantity control, p. 118
Quota, p. 118
Quota limit, p. 118
License, p. 118
Demand price, p. 119
Supply price, p. 119
Wedge, p. 121
Quota rent, p. 121
PROBLEMS
1. In order to ingratiate himself with voters, the mayor
of Gotham City decides to lower the price of taxi rides.
Assume, for simplicity, that all taxi rides are the same
distance and therefore cost the same. The accompanying table shows the demand and supply schedules for
taxi rides.
Fare (per ride)
Quantity of rides (millions per year)
Quantity demanded
Quantity supplied
$7.00
10
12
6.50
11
11
6.00
12
10
5.50
13
9
5.00
14
8
4.50
15
7
126 P A R T 2
S U P P LY A N D D E M A N D
a. Assume that there are no restrictions on the num-
ber of taxi rides that can be supplied (there is no
medallion system). Find the equilibrium price and
quantity.
Price of butter
(per pound)
b. Suppose that the mayor sets a price ceiling at $5.50.
1.15
How large is the shortage of rides? Illustrate with
a diagram. Who loses and who benefits from this
policy?
1.10
$1.20
S
1.05
E
1.00
c. Suppose that the stock market crashes and, as
a result, people in Gotham City are poorer. This
reduces the quantity of taxi rides demanded by
6 million rides per year at any given price. What
effect will the mayor’s new policy have now?
Illustrate with a diagram.
0.90
D
0.85
0
1.60
d. Suppose that the stock market rises and the demand
for taxi rides returns to normal (that is, returns to
the demand schedule given in the table). The mayor
now decides to ingratiate himself with taxi drivers.
He announces a policy in which operating licenses
are given to existing taxi drivers; the number of
licenses is restricted such that only 10 million rides
per year can be given. Illustrate the effect of this
policy on the market, and indicate the resulting
price and quantity transacted. What is the quota
rent per ride?
2. In the late eighteenth century, the price of bread in New
York City was controlled, set at a predetermined price
above the market price.
a. Draw a diagram showing the effect of the policy. Did
the policy act as a price ceiling or a price floor?
b. What kinds of inefficiencies were likely to have arisen
when the controlled price of bread was above the
market price? Explain in detail.
One year during this period, a poor wheat harvest
caused a leftward shift in the supply of bread and therefore an increase in its market price. New York bakers
found that the controlled price of bread in New York
was below the market price.
c. Draw a diagram showing the effect of the price con-
trol on the market for bread during this one­-­year
period. Did the policy act as a price ceiling or a
price floor?
d. What kinds of inefficiencies do you think occurred
during this period? Explain in detail.
1.65
1.70
Quantity of butter
(billions of pounds)
a. In the absence of a price floor, how much consumer
surplus is created? How much producer surplus?
What is the total surplus?
b. With the price floor at $1.05 per pound of butter,
consumers buy 1.6 billion pounds of butter. How
much consumer surplus is created now?
c. With the price floor at $1.05 per pound of butter,
producers sell 1.7 billion pounds of butter (some to
consumers and some to the USDA). How much producer surplus is created now?
d. How much money does the USDA spend on buying
up surplus butter?
e. Taxes must be collected to pay for the purchases
of surplus butter by the USDA. As a result, total
surplus (producer plus consumer) is reduced by the
amount the USDA spent on buying surplus butter.
Using your answers for parts b–d, what is the total
surplus when there is a price floor? How does this
compare to the total surplus without a price floor
from part a?
4. The accompanying table shows hypothetical demand
and supply schedules for milk per year. The U.S. government decides that the incomes of dairy farmers should
be maintained at a level that allows the traditional family dairy farm to survive. So it implements a price floor
of $1 per pint by buying surplus milk until the market
price is $1 per pint.
3. The U.S. Department of Agriculture (USDA) adminis-
ters the price floor for butter, which the 2008 Farm Bill
set at $1.05 per pound. At that price, according to data
from the USDA, the quantity of butter supplied in 2010
was 1.7 billion pounds, and the quantity demanded
was 1.6 billion pounds. To support the price of butter
at the price floor, the USDA therefore had to buy up
100 million pounds of butter. The accompanying diagram shows supply and demand curves illustrating the
market for butter.
Price
floor
0.95
Price of milk
(per pint)
Quantity of milk (millions of pints per year)
Quantity
Quantity
demanded
supplied
$1.20
550
850
1.10
600
800
1.00
650
750
0.90
700
700
0.80
750
650
a. How much surplus milk will be produced as a result
of this policy?
b. What will be the cost to the government of this
policy?
CHAPTER 4
P R I C E C O N T R O L S A N D Q U O TA S : M E D D L I N G W I T H M A R K E T S
c. Since milk is an important source of protein and
calcium, the government decides to provide the
surplus milk it purchases to elementary schools at
a price of only $0.60 per pint. Assume that schools
will buy any amount of milk available at this low
price. But parents now reduce their purchases
of milk at any price by 50 million pints per year
because they know their children are getting milk at
school. How much will the dairy program now cost
the government?
price for each unit sold. Consider the market for corn
depicted in the accompanying diagram.
Price of corn
(per bushel)
S
$5
4
3
d. Explain how inefficiencies in the form of inefficient
2
allocation to sellers and wasted resources arise from
this policy.
1
5. European governments tend to make greater use of
0
price controls than does the U.S. government. For
example, the French government sets minimum starting
yearly wages for new hires who have completed le bac,
certification roughly equivalent to a high school diploma. The demand schedule for new hires with le bac and
the supply schedule for similarly credentialed new job
seekers are given in the accompanying table. The price
here—given in euros, the currency used in France—is
the same as the yearly wage.
127
E
D
800
1,000 1,200
Quantity of corn (bushels)
a. If the government sets a price floor of $5 per bushel,
how many bushels of corn are produced? How many
are purchased by consumers? By the government?
How much does the program cost the government?
How much revenue do corn farmers receive?
b. Suppose the government sets a target price of $5 per
bushel for any quantity supplied up to 1,000 bushels.
How many bushels of corn are purchased by consumers and at what price? By the government? How
much does the program cost the government? How
much revenue do corn farmers receive?
Wage
(per year)
Quantity demanded
(new job offers
per year)
Quantity supplied
(new job seekers
per year)
w45,000
200,000
325,000
40,000
220,000
320,000
c. Which of these programs (in parts a and b) costs
35,000
250,000
310,000
30,000
290,000
290,000
corn consumers more? Which program costs the
government more? Explain.
25,000
370,000
200,000
a. In the absence of government interference, what
are the equilibrium wage and number of graduates
hired per year? Illustrate with a diagram. Will there
be anyone seeking a job at the equilibrium wage
who is unable to find one—that is, will there be anyone who is involuntarily unemployed?
b. Suppose the French government sets a minimum
yearly wage of €35,000. Is there any involuntary
unemployment at this wage? If so, how much?
Illustrate with a diagram. What if the minimum wage
is set at €40,000? Also illustrate with a diagram.
d. Is one of these policies less inefficient than the
other? Explain.
7. The waters off the North Atlantic coast were once teem-
ing with fish. But because of over­f ishing by the commercial fishing industry, the stocks of fish became seriously
depleted. In 1991, the National Marine Fishery Service
of the U.S. government implemented a quota to allow
fish stocks to recover. The quota limited the amount of
swordfish caught per year by all U.S.-licensed fishing
boats to 7 million pounds. As soon as the U.S. fishing
fleet had met the quota limit, the swordfish catch was
closed down for the rest of the year. The accompanying
table gives the hypothetical demand and supply schedules for swordfish caught in the United States per year.
c. Given your answer to part b and the information
in the table, what do you think is the relationship
between the level of involuntary unemployment and
the level of the minimum wage? Who benefits from
such a policy? Who loses? What is the missed opportunity here?
6. For the last 80 years the U.S. government has used price
supports to provide income assistance to American
farmers. To implement these price supports, at times
the government has used price floors, which it maintains by buying up the surplus farm products. At other
times, it has used target prices, a policy by which the
government gives the farmer an amount equal to the
difference between the market price and the target
Price of swordfish
(per pound)
Quantity of swordfish
(millions of pounds per year)
Quantity
Quantity
demanded
supplied
$20
6
15
18
7
13
16
8
11
14
9
9
12
10
7
a. Use a diagram to show the effect of the quota on the
market for swordfish in 1991.
128 P A R T 2
S U P P LY A N D D E M A N D
b. How do you think fishermen will change how they
fish in response to this policy?
8. In Maine, you must have a license to harvest lobster
commercially; these licenses are issued yearly. The state
of Maine is concerned about the dwindling supplies of
lobsters found off its coast. The state fishery department
has decided to place a yearly quota of 80,000 pounds
of lobsters harvested in all Maine waters. It has also
decided to give licenses this year only to those fishermen
who had licenses last year. The accompanying diagram
shows the demand and supply curves for Maine lobsters.
160
140
120
100
19
75
19
76
19
77
19
78
19
79
19
80
19
81
19
82
19
83
19
84
19
85
Price of
lobster
(per pound)
$22
20
18
16
14
12
10
8
6
4
0
Price of airline
ticket (index:
1975 = 100)
Year
Source: U.S. Bureau of Labor Statistics.
E
S
D
20
40
60
80
100 120 140
Quantity of lobsters (thousands of pounds)
a. In the absence of government restrictions, what are
the equilibrium price and quantity?
b. What is the demand price at which consumers wish
to purchase 80,000 pounds of lobsters?
c. What is the supply price at which suppliers are will-
ing to supply 80,000 pounds of lobsters?
d. What is the quota rent per pound of lobster when
80,000 pounds are sold?
e. Explain a transaction that benefits both buyer and
seller but is prevented by the quota restriction.
9. The accompanying diagram shows data from the U.S.
Bureau of Labor Statistics on the average price of an
airline ticket in the United States from 1975 until 1985,
adjusted to eliminate the effect of inflation (the general
increase in the prices of all goods over time). In 1978,
the United States Airline Deregulation Act removed the
price floor on airline fares, and it also allowed the airlines greater flexibility to offer new routes.
a. Looking at the data on airline ticket prices in the
diagram, do you think the price floor that existed
before 1978 was binding or non­binding? That is, do
you think it was set above or below the equilibrium
price? Draw a supply and demand diagram, showing
where the price floor that existed before 1978 was in
relation to the equilibrium price.
b. Most economists agree that the average airline ticket
price per mile traveled actually fell as a result of the
Airline Deregulation Act. How might you reconcile
that view with what you see in the diagram?
10. Many college students attempt to land internships
before graduation to burnish their resumes, gain experience in a chosen field, or try out possible careers. The
hope shared by all of these prospective interns is that
they will find internships that pay more than typical
summer jobs, such as waiting tables or flipping burgers.
a. With wage measured on the vertical axis and number of hours of work on the horizontal axis, draw
a supply and demand diagram for the market for
interns in which the minimum wage is non-binding
at the market equilibrium.
b. Assume that a market downturn reduces the demand
for interns by employers. However, many students
are willing and eager to work in unpaid internships.
As a result, the new market equilibrium wage is
equal to zero. Draw another supply and demand diagram to illustrate this new market equilibrium.
CHAPTER 4
P R I C E C O N T R O L S A N D Q U O TA S : M E D D L I N G W I T H M A R K E T S
WORK IT OUT
For interactive, step-by-step help in solving the following problem,
visit
by using the URL on the back cover of this book.
11. S
uppose it is decided that rent control in New York
City will be abolished and that market rents will now
prevail. Assume that all rental units are identical and
so are offered at the same rent. To address the plight
of residents who may be unable to pay the market
rent, an income supplement will be paid to all low­-­
income households equal to the difference between
the old controlled rent and the new market rent.
a. Use a diagram to show the effect on the rental
market of the elimination of rent control. What
will happen to the quality and quantity of rental
housing supplied?
b. Use a second diagram to show the additional
effect of the income­-­supplement policy on the
market. What effect does it have on the market
rent and quantity of rental housing supplied in
comparison to your answers to part a?
c. Are tenants better or worse off as a result of these
policies? Are landlords better or worse off? Is
society as a whole better or worse off?
d. From a political standpoint, why do you think cit-
ies have been more likely to resort to rent control
rather than a policy of income supplements to
help low­-­income people pay for housing?
129
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CHAPTER
International Trade
W
W
RLD VIE
O
s
What You Will Learn
in This Chapter
5
•
THE EVERYWHERE PHONE
How comparative advantage
leads to mutually beneficial
international trade
The sources of international
•comparative
advantage
Who gains and who loses from
•international
trade, and why the
total surplus
governments often engage
•in Why
trade protection and how
international trade agreements
counteract this
“W
Imaginechina/Corbis
How tariffs and import quotas
•cause
inefficiency and reduce
Vlad Teodor/Shutterstock
gains exceed the losses
The production and consumption of smartphones are examples of today’s hyperglobal
world with its soaring levels of international trade.
E FELL IN LOVE WHEN I
was nineteen / Now we’re
staring at a screen.” These
lyrics, from Arcade Fire’s 2013 hit song
“Reflektor,” describe an era in which
everyone does indeed seem to be staring at the screen of a smartphone. Apple
introduced its first iPhone in 2007, and
since then the iPhone and its competitors have become ubiquitous.
They’re everywhere—but where do
smartphones come from? If you answered
“America,” because Apple is an American
company, you’re mostly wrong: Apple
develops products, but outsources nearly
all manufacturing of those products to
other companies, mainly overseas. But it’s
not really right to say “China” either, even
though that’s where iPhones are assembled. You see, assembly—the last phase
of iPhone production, in which the pieces
are put together in the familiar metal-andglass case—only accounts for a small fraction of the phone’s value.
In fact, a study of the iPhone 4 estimated that of the average factory price
of $229 per phone, only around $10
stayed in the Chinese economy. A substantially larger amount went to Korean
manufacturers, who supplied the display
and memory chips. There were also
substantial outlays for raw materials,
sourced all over the world. And the
biggest share of the price—more than
half—consisted of Apple’s profit margin,
which was largely a reward for research,
development, and design.
So where do iPhones come from? Lots
of places. And the case of the iPhone
isn’t unusual: the car you drive, the
clothing you wear, even the food you eat
are generally the end products of complex “supply chains” that span the globe.
Has this always been true? Yes and
no. Large-scale international trade
isn’t new. By the early twentieth century, middle-class residents of London
already ate bread made from Canadian
wheat and beef from the Argentine
Pampas, while wearing clothing woven
from Australian wool and Egyptian cotton. In recent decades, however, new
technologies for transportation and
communication have interacted with
pro-trade policies to produce an era of
hyperglobalization in which international trade has soared thanks to complex
chains of production like the one that
puts an iPhone in front of your nose. As
a result, now, more than ever before,
we must have a full picture of international trade to understand how national
economies work.
This chapter examines the economics
of international trade. We start from the
model of comparative advantage, which,
as we saw in Chapter 2, explains why
there are gains from international trade.
We will briefly recap that model here,
then turn to a more detailed examination of the causes and consequences of
globalization.
131
132 P A R T 2
S U P P LY A N D D E M A N D
Goods and services purchased from
other countries are imports; goods
and services sold to other countries
are exports.
Globalization is the phenomenon
of growing economic linkages
among countries.
Hyperglobalization is the
phenomenon of extremely high levels
of international trade.
The United States buys smartphones—and many other goods and services—
from other countries. At the same time, it sells many goods and services to other
countries. Goods and services purchased from abroad are imports; goods and
services sold abroad are exports.
As illustrated by the opening story, imports and exports have taken on an
increasingly important role in the U.S. economy. Over the last 50 years, both
imports into and exports from the United States have grown faster than the
U.S. economy. Panel (a) of Figure 5-1 shows how the values of U.S. imports and
exports have grown as a percentage of gross domestic product (GDP). Panel (b)
shows imports and exports as a percentage of GDP for a number of countries. It
shows that foreign trade is significantly more important for many other countries
than it is for the United States. (Japan is the exception.)
Foreign trade isn’t the only way countries interact economically. In the modern world, investors from one country often invest funds in another nation; many
companies are multinational, with subsidiaries operating in several countries;
and a growing number of individuals work in a country different from the one in
which they were born. The growth of all these forms of economic linkages among
countries is often called globalization. And as we saw in the opening story, certain sectors of the economy are characterized by extremely high levels of international trade. This hyperglobalization is often the result of supply chains of
production that span the globe, in which each stage of a good’s production takes
place in a different country—all made possible by advances in communication
and transportation technology. (We analyze a real-life example in this chapter’s
business case.)
The Growing Importance of International Trade
(a) U.S. Imports and Exports, 1960–2013
Percent
of GDP
20%
Percent
of GDP
90%
18
Imports
Exports
80
Imports
16
70
14
60
12
50
10
40
8
30
6
4
20
Exports
n
Ja
pa
na
Ch
i
Fr
an
ce
rm
an
y
Me
xic
o
Ca
na
da
um
Un
i
Ge
lg
i
2010 2013
Year
at
2000
St
1990
d
1980
te
1970
es
10
2
1960
(b) Imports and Exports for Different Countries, 2012
Be
FIGURE 5-1
Comparative Advantage and
International Trade
Panel (a) illustrates the fact that over the past 50 years, the
United States has exported a steadily growing share of its
GDP to other countries and imported a growing share of what
it consumes. Panel (b) demonstrates that international trade is
significantly more important to many other countries than it is to
the United States, with the exception of Japan.
Sources: Bureau of Economic Analysis [panel (a)] and World Development
Indicators [panel (b)].
CHAPTER 5
I N T E R N AT I O N A L T R A D E
133
In this chapter, however, we’ll focus mainly on international trade. To understand why international trade occurs and why economists believe it is beneficial
to the economy, we will first review the concept of comparative advantage.
To produce phones, any country must use resources—land, labor, capital, and so
on—that could have been used to produce other things. The potential production
of other goods a country must forgo to produce a phone is the opportunity cost
of that phone.
In some cases, it’s easy to see why the opportunity cost of
producing a good is especially low in a given country. Consider,
for example, shrimp—much of which now comes from seafood
farms in Vietnam and Thailand. It’s a lot easier to produce
shrimp in Vietnam, where the climate is nearly ideal and there’s
plenty of coastal land suitable for shellfish farming, than it is in
the United States.
Conversely, other goods are not produced as easily in Vietnam as
in the United States. For example, Vietnam doesn’t have the base of
skilled workers and technological know-how that makes the United
States so good at producing many high-technology goods. So the
opportunity cost of a ton of shrimp, in terms of other goods such
The opportunity cost of assembling smartphones in
as aircraft, is much less in Vietnam than it is in the United States.
China is lower, giving it a comparative advantage.
In other cases, matters are a bit less obvious. It’s as easy to
assemble smartphones in the United States as it is in China, and
Chinese electronics workers are, if anything, less efficient than their U.S. counterparts. But Chinese workers are a lot less productive than U.S. workers in other
areas, such as automobile and chemical production. This means that diverting a
Chinese worker into assembling phones reduces output of other goods less than
diverting a U.S. worker into assembling phones. That is, the opportunity cost of
assembling phones in China is less than it is in the United States.
Notice that we said the opportunity cost of assembling phones. As we’ve seen,
most of the value of a “Chinese made” phone actually comes from other countries.
For the sake of exposition, however, let’s ignore that complication and consider a
hypothetical case in which China makes phones from scratch.
So we say that China has a comparative advantage in producing smartphones.
Let’s repeat the definition of comparative advantage from Chapter 2: A country
has a comparative advantage in producing a good or service if the opportunity cost
of producing the good or service is lower for that country than for other countries.
Figure 5-2 provides a hypothetical numerical example of comparative advantage in international trade. We assume that only two goods are produced and
consumed, phones and Ford trucks, and that there are only two countries in the
world, the United States and China. The figure shows hypothetical production
possibility frontiers for the United States and China.
As in Chapter 2, we simplify the model by assuming that the production
possibility frontiers are straight lines, as shown in Figure 2-1, rather than the
more realistic bowed-out shape shown in Figure 2-2. The straight-line shape
implies that the opportunity cost of a phone in terms of trucks in each country
is constant—it does not depend on how many units of each good the country
produces. The analysis of international trade under the assumption that opportunity costs are constant, which makes production possibility frontiers straight
lines, is known as the Ricardian model of international trade, named after
The Ricardian model of
the English economist David Ricardo, who introduced this analysis in the early
international trade analyzes
nineteenth century.
international trade under the
In Figure 5-2 we show a situation in which the United States can produce
assumption that opportunity costs
100,000 trucks if it produces no phones, or 100 million phones if it produces
are constant.
Shutterstock
Production Possibilities and Comparative
Advantage, Revisited
134 P A R T 2
FIGURE 5-2
S U P P LY A N D D E M A N D
Comparative Advantage and the Production Possibility Frontier
(a) U.S. Production Possibility Frontier
Quantity of
trucks
Quantity of
trucks
100,000
50,000
(b) China’s Production Possibility Frontier
U.S. production
and consumption
in autarky
CUS
China’s production
and consumption
in autarky
50,000
25,000
CChina
China PPF
U.S. PPF
0
50
0
100
Quantity of phones
(millions)
The U.S. opportunity cost of 1 million phones in terms of
trucks is 1,000: for every 1 million phones, 1,000 trucks must
be forgone. The Chinese opportunity cost of 1 million phones
in terms of trucks is 250 for every additional 1 million phones,
only 250 trucks must be forgone. As a result, the United States
100
200
Quantity of phones
(millions)
has a comparative advantage in truck production, and China
has a comparative advantage in phone production. In autarky,
each country is forced to consume only what it produces:
50,000 trucks and 50 million phones for the United States;
25,000 trucks and 100 million phones for China.
no trucks. Thus, the slope of the U.S. production possibility frontier, or PPF,
is −100,000/100 = −1,000. That is, to produce an additional million phones, the
United States must forgo the production of 1,000 trucks.
Similarly, China can produce 50,000 trucks if it produces no phones or
200 million phones if it produces no trucks. Thus, the slope of China’s PPF is
−50,000/200 = −250. That is, to produce an additional million phones, China must
forgo the production of 250 trucks.
Economists use the term autarky to refer to a situation in which a
country does not trade with other countries. We assume that in autarky the
United States chooses to produce and consume 50 million phones and 50,000
trucks. We also assume that in autarky China produces 100 million phones
and 25,000 trucks.
The trade-offs facing the two countries when they don’t trade are summarized in Table 5-1. As you can see, the United States has a comparative advantage
in the production of trucks because it has a lower opportunity cost in terms
of phones than China has: producing
a truck costs the United States only
U.S. and Chinese Opportunity Costs of Phones
1,000 phones, while it costs China 4,000
TABLE 5-1
and Trucks
phones. Correspondingly, China has a
U.S. Opportunity Cost
Chinese Opportunity Cost
comparative advantage in phone production: 1 million phones costs only 250
1 million phones
>
1,000 trucks
250 trucks
trucks, while it costs the United States
1 truck
<
1,000 phones
4,000 phones
1,000 trucks.
As we learned in Chapter 2, each
country can do better by engaging in trade than it could by not trading. A country
can accomplish this by specializing in the production of the good in which it has
a comparative advantage and exporting that good, while importing the good in
which it has a comparative disadvantage.
Let’s see how this works.
Autarky is a situation in which a
country does not trade with other
countries.
CHAPTER 5
(a) U.S. Production and Consumption
100,000
(b) China’s Production and Consumption
Quantity of
trucks
U.S. production
with trade
China’s production
and consumption
in autarky
U.S. consumption
with trade
62,500
50,000
China’s
consumption
with trade
China’s
production
with trade
50,000
37,500
25,000
U.S. production
and consumption
in autarky
China PPF
U.S. PPF
0
50
75
100
0
100 125
Quantity of phones
(millions)
Trade increases world production of both goods, allowing both
countries to consume more. Here, each country specializes its
production as a result of trade: the United States concentrates
on producing trucks, and China concentrates on producing
200
Quantity of phones
(millions)
phones. Total world production of both goods rises, which
means that it is possible for both countries to consume more of
both goods.
The Gains from International Trade
Figure 5-3 illustrates how both countries can gain from specialization and trade,
by showing a hypothetical rearrangement of production and consumption that
allows each country to consume more of both goods. Again, panel (a) represents
the United States and panel (b) represents China. In each panel we indicate again
the autarky production and consumption assumed in Figure 5-2.
Once trade becomes possible, however, everything changes. With trade, each
country can move to producing only the good in which it has a comparative
advantage—trucks for the United States and phones for China. Because the world
production of both goods is now higher than in autarky, trade makes it possible
for each country to consume more of both goods.
Table 5-2 sums up the changes as a result of trade and shows why both countries can gain. The left part of the table shows the autarky situation, before trade,
in which each country must produce the goods it consumes. The right part of
the table shows what happens as a result of trade. After trade, the United States
specializes in the production of trucks, producing 100,000 trucks and no phones;
China specializes in the production of phones, producing 200 million phones and
no trucks.
TABLE 5-2
How the United States and China Gain from Trade
In Autarky
Production
United States
China
135
The Gains from International Trade
FIGURE 5-3
Quantity of
trucks
I N T E R N AT I O N A L T R A D E
Million phones
Trucks
Million phones
Trucks
With Trade
Consumption
Production
Consumption
Gains from trade
50
50
0
75
+25
50,000
50,000
100,000
62,500
+12,500
100
100
200
125
+25
25,000
25,000
0
37,500
+12,500
136 P A R T 2
S U P P LY A N D D E M A N D
The result is a rise in total world production of both goods. As you can see
in the Table 5-2 column at far right showing consumption with trade, the United
States is able to consume both more trucks and more phones than before, even
though it no longer produces phones, because it can import phones from China.
China can also consume more of both goods, even though it no longer produces
trucks, because it can import trucks from the United States.
The key to this mutual gain is the fact that trade liberates both countries
from self-sufficiency—from the need to produce the same mixes of goods they
consume. Because each country can concentrate on producing the good in which
it has a comparative advantage, total world production rises, making a higher
standard of living possible in both nations.
In this example we have simply assumed the post-trade consumption bundles
of the two countries. In fact, the consumption choices of a country reflect both
the preferences of its residents and the relative prices—the prices of one good in
terms of another in international markets. Although we have not explicitly given
the price of trucks in terms of phones, that price is implicit in our example: China
sells the United States the 75 million phones the U.S. consumes in return for the
37,500 trucks China consumes, so 1 million phones are traded for 500 trucks.
This tells us that the price of a truck on world markets must be equal to the price
of 2,000 phones in our example.
One requirement that the relative price must satisfy is that no country pays a
relative price greater than its opportunity cost of obtaining the good in autarky.
That is, the United States won’t pay more than 1,000 trucks for one million phones
from China, and China won’t pay more than 4,000 phones for each truck from
the United States. Once this requirement is satisfied, the actual relative price in
international trade is determined by supply and demand—and we’ll turn to supply and demand in international trade in the next section. However, first let’s look
more deeply into the nature of the gains from trade.
Pornchai Kittiwongsakul/AFP/Getty Images
Comparative Advantage versus Absolute Advantage
It’s easy to accept the idea that Vietnam and Thailand have a comparative advantage in shrimp production: they have a tropical climate that’s better suited to
shrimp farming than that of the United States (even along the Gulf Coast), and
they have a lot of usable coastal area. So the United States imports shrimp from
Vietnam and Thailand. In other cases, however, it may be harder to understand
why we import certain goods from abroad.
U.S. imports of phones from China are a case in point. There’s
nothing about China’s climate or resources that makes it especially
good at assembling electronic devices. In fact, it almost surely
would take fewer hours of labor to assemble a smartphone or a
tablet in the United States than in China.
Why, then, do we buy phones assembled in China? Because the
gains from trade depend on comparative advantage, not absolute
advantage. Yes, it would take less labor to assemble a phone in the
United States than in China. That is, the productivity of Chinese
electronics workers is less than that of their U.S. counterparts.
But what determines comparative advantage is not the amount
of resources used to produce a good but the opportunity cost of
that good—here, the quantity of other goods forgone in order to
produce a phone. And the opportunity cost of phones is lower in
China than in the United States.
Here’s how it works: Chinese workers have low productivity compared with U.S. workers in the electronics industry. But
Chinese workers have even lower productivity compared with U.S.
The tropical climates of Vietnam and Thailand give them
workers in other industries. Because Chinese labor productivity
a comparative advantage in shrimp production.
CHAPTER 5
I N T E R N AT I O N A L T R A D E
137
in industries other than electronics is relatively very low, producing a phone in
China, even though it takes a lot of labor, does not require forgoing the production of large quantities of other goods.
In the United States, the opposite is true: very high productivity in other
industries (such as automobiles) means that assembling electronic products in
the United States, even though it doesn’t require much labor, requires sacrificing lots of other goods. So the opportunity cost of producing electronics is less
in China than in the United States. Despite its lower labor productivity, China
has a comparative advantage in the production of many consumer electronics,
although the United States has an absolute advantage.
The source of China’s comparative advantage in consumer electronics is
reflected in global markets by the wages Chinese workers are paid. That’s
because a country’s wage rates, in general, reflect its labor productivity.
In countries where labor is highly productive in many industries, employers are willing to pay high wages to attract workers, so competition among
employers leads to an overall high wage rate. In countries where labor is less
productive, competition for workers is less intense and wage rates are correspondingly lower.
As the accompanying Global Comparison shows, there is indeed a strong
relationship between overall levels of productivity and wage rates around
the world. Because China has generally low productivity, it has a relatively
low wage rate. Low wages, in turn, give China a cost advantage in producing
goods where its productivity is only moderately low, like consumer electronics. As a result, it’s cheaper to produce these goods in China than in the
United States.
The kind of trade that takes place between low-wage, low-productivity economies like China and high-wage, high-productivity economies like the United
States gives rise to two common misperceptions. One, the pauper labor fallacy,
is the belief that when a country with high wages imports goods produced by
workers who are paid low wages, this must hurt the standard of living of workers
GLOBAL
COMPARISION
Productivity and Wages Around the World
I
s it true that both the pauper labor argument and the
sweatshop labor argument are fallacies? Yes, it is. The real
explanation for low wages in poor countries is low overall
productivity.
The graph shows estimates of labor productivity, measured by the value of output (GDP) per worker, and wages,
measured by the hourly compensation of the average worker,
for several countries in 2012. Both productivity and wages
are expressed as percentages of U.S. productivity and
wages; for example, productivity and wages in Japan were
70% and 101%, respectively, of their U.S. levels. You can
see the strong positive relationship between productivity and wages. The relationship isn’t perfect. For example,
Norway has higher wages than its productivity might lead
you to expect. But simple comparisons of wages give a
misleading sense of labor costs in poor countries: their low
wage advantage is mostly offset by low productivity.
Sources: The Conference Board; Penn World Table 8.0.
Wage (percent
of U.S. wage)
180%
160
140
120
100
80
60
40
20
0
Belgium
Denmark
Australia
Norway
Switzerland
Sweden
Germany
Finland
Ireland
France
Austria Netherlands
Canada
Italy
United Kingdom
Japan
United States
New Zealand
Spain
Greece
Singapore
Czech Republic
Korea
Argentina
Israel
Portugal
Brazil Estonia
Slovakia
Taiwan
Mexico
Poland
Philippines
Hungary
20
40
60
80
100 120%
Productivity (percent of U.S. productivity)
138 P A R T 2
S U P P LY A N D D E M A N D
in the importing country. The other, the sweatshop labor fallacy, is the belief that
trade must be bad for workers in poor exporting countries because those workers
are paid very low wages by our standards.
Both fallacies miss the nature of gains from trade: it’s to the advantage of
both countries if the poorer, lower-wage country exports goods in which it has
a comparative advantage, even if its cost advantage in these goods depends on
low wages. That is, both countries are able to achieve a higher standard of living
through trade.
It’s particularly important to understand that buying a good made by someone who is paid much lower wages than most U.S. workers doesn’t necessarily
imply that you’re taking advantage of that person. It depends on the alternatives.
Because workers in poor countries have low productivity across the board, they
are offered low wages whether they produce goods exported to America or goods
sold in local markets. A job that looks terrible by rich-country standards can be
a step up for someone in a poor country.
International trade that depends on low-wage exports can nonetheless raise
the exporting country’s standard of living. This is especially true of very-low-wage
nations. For example, Bangladesh and similar countries would be much poorer
than they are—their citizens might even be starving—if they weren’t able to
export goods such as clothing based on their low wage rates.
Sources of Comparative Advantage
International trade is driven by comparative advantage, but where does comparative advantage come from? Economists who study international trade have
found three main sources of comparative advantage: international differences in
climate, international differences in factor endowments, and international differences in technology.
Differences in Climate One key reason the opportunity cost of producing
Johner Images/Alamy
shrimp in Vietnam and Thailand is less than in the United States is that
shrimp need warm water—Vietnam has plenty of that, but America doesn’t.
In general, differences in climate play a significant role in international
trade. Tropical countries export tropical products like coffee, sugar, bananas, and shrimp. Countries in the temperate zones export crops like wheat
and corn. Some trade is even driven by the difference in seasons between
the northern and southern hemispheres: winter deliveries of Chilean grapes
and New Zealand apples have become commonplace in U.S. and European
supermarkets.
A greater endowment of forestland
gives Canada a comparative advantage in forest products.
Differences in Factor Endowments Canada is a major exporter of forest
products—lumber and products derived from lumber, like pulp and paper—to
the United States. These exports don’t reflect the special skill of Canadian lumberjacks. Canada has a comparative advantage in forest products because its
forested area is much greater compared to the size of its labor force than the ratio
of forestland to the labor force in the United States.
Forestland, like labor and capital, is a factor of production: an input used to
produce goods and services. (Recall from Chapter 2 that the factors of production
are land, labor, physical capital, and human capital.) Due to history and geography,
the mix of available factors of production differs among countries, providing an
important source of comparative advantage. The relationship between comparative
advantage and factor availability is found in an influential model of international
trade, the Heckscher–Ohlin model, developed by two Swedish economists in the
first half of the twentieth century.
CHAPTER 5
Two key concepts in the model are factor abundance and factor intensity.
Factor abundance refers to how large a country’s supply of a factor is relative to
its supply of other factors. Factor intensity refers to the fact that producers use
different ratios of factors of production in the production of different goods. For
example, oil refineries use much more capital per worker than clothing factories.
Economists use the term factor intensity to describe this difference among
goods: oil refining is capital-intensive, because it tends to use a high ratio of
capital to labor, but phone production is labor-intensive, because it tends to use a
high ratio of labor to capital.
According to the Heckscher–Ohlin model, a country that has an abundant
supply of a factor of production will have a comparative advantage in goods
whose production is intensive in that factor. So a country that has a relative
abundance of capital will have a comparative advantage in capital-intensive
industries such as oil refining, but a country that has a relative abundance of
labor will have a comparative advantage in labor-intensive industries such as
phone production.
The basic intuition behind this result is simple and based on opportunity cost.
The opportunity cost of a given factor—the value that the factor would generate in
alternative uses—is low for a country when it is relatively abundant in that factor.
Relative to the United States, China has an abundance of low-skilled labor. As a
result, the opportunity cost of the production of low-skilled, labor-intensive goods
is lower in China than in the United States.
The most dramatic example of the validity of the Heckscher–Ohlin model is
world trade in clothing. Clothing production is a labor-intensive activity: it doesn’t
take much physical capital, nor does it require a lot of human capital in the form
of highly educated workers. So you would expect labor-abundant countries such
as China and Bangladesh to have a comparative advantage in clothing production. And they do.
The fact that international trade is the result of differences in factor
endowments helps explain another fact: international specialization of production is often incomplete. That is, a country often maintains some domestic
production of a good that it imports. A good example of this is the United
States and oil. Saudi Arabia exports oil to the United States because Saudi
Arabia has an abundant supply of oil relative to its other factors of production; the United States exports medical devices to Saudi Arabia because it
has an abundant supply of expertise in medical technology relative to its
other factors of production. But the United States also produces some oil
domestically because the size of its domestic oil reserves in Texas and Alaska
(and now, increasingly, its oil shale reserves elsewhere) makes it economical
to do so.
In our supply and demand analysis in the next section, we’ll consider incomplete specialization by a country to be the norm. We should emphasize, however,
that the fact that countries often incompletely specialize does not in any way
change the conclusion that there are gains from trade.
Differences in Technology In the 1970s and 1980s, Japan became by far
the world’s largest exporter of automobiles, selling large numbers to the United
States and the rest of the world. Japan’s comparative advantage in automobiles
wasn’t the result of climate. Nor can it easily be attributed to differences in
factor endowments: aside from a scarcity of land, Japan’s mix of available
factors is quite similar to that in other advanced countries. Instead, Japan’s
comparative advantage in automobiles was based on the superior production
techniques developed by its manufacturers, which allowed them to produce
more cars with a given amount of labor and capital than their American or
European counterparts.
I N T E R N AT I O N A L T R A D E
139
The factor intensity of production
of a good is a measure of which
factor is used in relatively greater
quantities than other factors in
production.
According to the Heckscher–Ohlin
model, a country has a comparative
advantage in a good whose
production is intensive in the factors
that are abundantly available in that
country.
also called economies of scale) can give
rise to monopoly, a situation in which
an industry is composed of only one
producer, because it gives large firms a
cost advantage over small ones.
But increasing returns to scale can
also give rise to international trade. The
logic runs as follows: if production of
a good is characterized by increasing returns to scale, it makes sense to
concentrate production in only a few
locations, so each location has a high
level of output. But that also means production occurs in only a few countries
that export the good to other countries.
A commonly cited example is the North
American auto industry: although both
the United States and Canada produce
automobiles and their components, each
particular model or component tends
to be produced in only one of the two
countries and exported to the other.
Increasing returns to scale probably play
Thinkstock
Most analyses of international trade
focuses on how differences between
countries—differences in climate, factor
endowments, and technology—create
national comparative advantage.
However, economists have also pointed
out another reason for international
trade: the role of increasing returns
to scale.
Production of a good is characterized by increasing returns to scale if the
productivity of labor and other resources
used in production rise with the quantity
of output. For example, in an industry
characterized by increasing returns to
scale, increasing output by 10% might
require only 8% more labor and 9%
more raw materials. Examples of industries with increasing returns to scale
include auto manufacturing, oil refining,
and the production of jumbo jets, all of
which require large outlays of capital.
Increasing returns to scale (sometimes
RLD VIE
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Increasing Returns to Scale
and International Trade
FOR INQUIRING MINDS
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Returns to scale in the auto industry leads
to international trade in autos and auto
parts.
a large role in the trade in manufactured
goods between advanced countries,
which is about 25% of the total value of
world trade.
•
in Action
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Japan’s comparative advantage in automobiles was a case of comparative
advantage caused by differences in technology—the techniques used in production.
The causes of differences in technology are somewhat mysterious. Sometimes
they seem to be based on knowledge accumulated through experience—for example, Switzerland’s comparative advantage in watches reflects a long tradition of
watchmaking. Sometimes they are the result of a set of innovations that for some
reason occur in one country but not in others. Technological advantage, however, is
often transitory. As we discussed in the Chapter 2 Business Case, by adopting lean
production, American auto manufacturers have now closed much of the gap in productivity with their Japanese competitors. In addition, Europe’s aircraft industry
has closed a similar gap with the U.S. aircraft industry. At any given point in time,
however, differences in technology are a major source of comparative advantage.
How Hong Kong Lost Its Shirts
T
Jennifer Thermes/Getty Images
140 P A R T 2
he rise of Hong Kong was one of the most improbablesounding economic success stories of the twentieth century.
When a communist regime took over China in 1949, Hong
Kong—which was still at that point a British colony—became in
effect a city without a hinterland, largely cut off from economic
relations with the territory just over the border. Since Hong Kong
had until that point made a living largely by serving as a point of
entry into China, you might have expected the city to languish.
Instead, however, Hong Kong prospered, to such an extent that
today the city—now returned to China, but governed as a special
autonomous region—has a GDP per capita comparable to that of
the United States.
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141
During much of its ascent, Hong Kong’s rise rested,
Education, Skill Intensity,
FIGURE 5-4
above all, on its clothing industry. In 1980 Hong Kong’s
and Trade
garment and textile sectors employed almost 450,000
workers, close to 20% of total employment. These
Share of U.S.
workers overwhelmingly made apparel—shirts, trouapparel imports
(percent)
sers, dresses, and more—for export, especially to the
16%
United States.
14
Since then, however, the Hong Kong clothing industry has fallen sharply in size—in fact, it has almost dis12
Hong Kong
appeared. So, too, have Hong Kong’s apparel exports.
10
Figure 5-4 shows Hong Kong’s share of U.S. apparel
8
imports since 1989, along with the share of a relative
6
Bangladesh
newcomer to the industry, Bangladesh. As you can see,
4
Hong Kong has more or less dropped off the chart,
while Bangladesh’s share has risen significantly in
2
recent years.
1988 1992 1996 2000 2004 2008 2012
Why did Hong Kong lose its comparative advanYear
tage in making shirts, pants, and so on? It wasn’t
Source: U.S. International Trade Administration.
because the city’s garment workers became less productive. Instead, it was because the city got better at
other things. Apparel production is a labor-intensive,
relatively low-tech industry; comparative advantage in that industry has historically always rested with poor, labor-abundant economies. Hong Kong no
Quick Review
longer fits that description; Bangladesh does. Hong Kong’s garment industry
•
Imports
and exports account
was a victim of the city’s success.
for a growing share of the U.S.
economy and the economies of
many other countries.
Check Your Understanding
• The growth of international
5-1
1. In the United States, the opportunity cost of 1 ton of corn is 50 bicycles. In China,
the opportunity cost of 1 bicycle is 0.01 ton of corn.
a. Determine the pattern of comparative advantage.
b. In autarky, the United States can produce 200,000 bicycles if no corn is produced,
and China can produce 3,000 tons of corn if no bicycles are produced. Draw each
country’s production possibility frontier assuming constant opportunity cost,
with tons of corn on the vertical axis and bicycles on the horizontal axis.
c. With trade, each country specializes its production. The United States consumes 1,000 tons of corn and 200,000 bicycles; China consumes 3,000 tons of
corn and 100,000 bicycles. Indicate the production and consumption points on
your diagrams, and use them to explain the gains from trade.
2. Explain the following patterns of trade using the Heckscher–Ohlin model.
a. France exports wine to the United States, and the United States exports movies
to France.
b. Brazil exports shoes to the United States, and the United States exports shoemaking machinery to Brazil.
Solutions appear at back of book.
Supply, Demand, and International Trade
Simple models of comparative advantage are helpful for understanding the
fundamental causes of international trade. However, to analyze the effects of
international trade at a more detailed level and to understand trade policy,
it helps to return to the supply and demand model. We’ll start by looking at
the effects of imports on domestic producers and consumers, then turn to the
effects of exports.
trade and other international
linkages is known as
globalization. Extremely high
levels of international trade are
known as hyperglobalization.
• International trade is driven
by comparative advantage.
The Ricardian model of
international trade shows that
trade between two countries
makes both countries better off
than they would be in autarky—
that is, there are gains from
international trade.
• The main sources of
comparative advantage are
international differences in
climate, factor endowments, and
technology.
• The Heckscher–Ohlin model
shows how comparative advantage
can arise from differences in
factor endowments: goods differ
in their factor intensity, and
countries tend to export goods
that are intensive in the factors
they have in abundance.
142 P A R T 2
S U P P LY A N D D E M A N D
The domestic demand curve
shows how the quantity of a good
demanded by domestic consumers
depends on the price of that good.
The domestic supply curve shows
how the quantity of a good supplied
by domestic producers depends on
the price of that good.
The world price of a good is the
price at which that good can be
bought or sold abroad.
FIGURE 5-5
The Effects of Imports
Figure 5-5 shows the U.S. market for phones, ignoring international trade for
a moment. It introduces a few new concepts: the domestic demand curve, the
domestic supply curve, and the domestic or autarky price.
The domestic demand curve shows how the quantity of a good demanded
by residents of a country depends on the price of that good. Why “domestic”?
Because people living in other countries may demand the good, too. Once we
introduce international trade, we need to distinguish between purchases of a
good by domestic consumers and purchases by foreign consumers. So the domestic demand curve reflects only the demand of residents of our own country.
Similarly, the domestic supply curve shows how the quantity of a good supplied by producers inside our own country depends on the price of that good.
Once we introduce international trade, we need to distinguish between the supply
of domestic producers and foreign supply—supply brought in from abroad.
In autarky, with no international trade in phones, the equilibrium in this market would be determined by the intersection of the domestic demand and domestic supply curves, point A. The equilibrium price of phones would be PA, and the
equilibrium quantity of phones produced and consumed would be QA. As always,
both consumers and producers gain from the existence of the domestic market.
Economists refer to the net gain that buyers receive from the purchase of a
good as consumer surplus. Likewise, producer surplus is the net gain to sellers
from selling a good. Total surplus is the sum of consumer and producer surplus.
We analyze these three concepts in detail in the appendix at the end of this
chapter. In autarky, consumer surplus would be equal to the area of the blueshaded triangle in Figure 5-5. Producer surplus would be equal to the area of
the red-shaded triangle. And total surplus would be equal to the sum of these
two shaded triangles.
Now let’s imagine opening up this market to imports. To do this, we must
make an assumption about the supply of imports. The simplest assumption,
which we will adopt here, is that unlimited quantities of phones can be purchased from abroad at a fixed price, known as the world price of phones.
Consumer and Producer Surplus in Autarky
In the absence of trade, the domestic price is PA , the autarky price at
which the domestic supply curve
and the domestic demand curve
intersect. The quantity produced
and consumed domestically is Q A .
Consumer surplus is represented by
the blue-shaded area, and producer
surplus is represented by the redshaded area.
Price of
phone
Domestic
supply
Consumer
surplus
PA
A
Producer
surplus
Domestic
demand
QA
Quantity of
phones
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Figure 5-6 shows a situation in which the world price of a phone, PW, is lower than
the price of a phone that would prevail in the domestic market in autarky, PA.
Given that the world price is below the domestic price of a phone, it is profitable for importers to buy phones abroad and resell them domestically. The
imported phones increase the supply of phones in the domestic market, driving
down the domestic market price. Phones will continue to be imported until the
domestic price falls to a level equal to the world price.
The result is shown in Figure 5-6. Because of imports, the domestic price of
a phone falls from PA to PW. The quantity of phones demanded by domestic consumers rises from QA to QD, and the quantity supplied by domestic producers falls
from QA to QS. The difference between the domestic quantity demanded and the
domestic quantity supplied, QD − QS, is filled by imports.
Now let’s turn to the effects of imports on consumer surplus and producer
surplus. Because imports of phones lead to a fall in their domestic price, consumer surplus rises and producer surplus falls. Figure 5-7 shows how this works.
We label four areas: W, X, Y, and Z. The autarky consumer surplus we identified
in Figure 5-5 corresponds to W, and the autarky producer surplus corresponds to
the sum of X and Y. The fall in the domestic price to the world price leads to an
increase in consumer surplus; it increases by X and Z, so consumer surplus now
equals the sum of W, X, and Z. At the same time, producers lose X in surplus, so
producer surplus now equals only Y.
The table in Figure 5-7 summarizes the changes in consumer and producer
surplus when the phone market is opened to imports. Consumers gain surplus
equal to the areas X + Z. Producers lose surplus equal to X. So the sum of producer and consumer surplus—the total surplus generated in the phone market—
increases by Z. As a result of trade, consumers gain and producers lose, but the
gain to consumers exceeds the loss to producers. This is an important result. We
have just shown that opening up a market to imports leads to a net gain in total
surplus, which is what we should have expected given the proposition that there
are gains from international trade.
FIGURE 5-6
The Domestic Market with Imports
Here the world price of phones,
PW , is below the autarky price, PA .
When the economy is opened to
international trade, imports enter the
domestic market, and the domestic
price falls from the autarky price, PA ,
to the world price, PW . As the price
falls, the domestic quantity demanded rises from Q A to QD and the
domestic quantity supplied falls from
Q A to QS . The difference between
domestic quantity demanded and
domestic quantity supplied at PW ,
the quantity QD − QS , is filled by
imports.
Price of
phone
Domestic
supply
Autarky
price
A
PA
PW
Domestic
demand
World
price
QS
Domestic quantity
supplied with trade
QA
Imports
QD
Quantity of
phones
Domestic quantity
demanded with trade
143
144 P A R T 2
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The Effects of Imports on Surplus
FIGURE 5-7
Price of
phone
Changes in surplus
Domestic
supply
Gain
Consumer surplus
X+Z
Producer surplus
W
Change in
total surplus
A
PA
X
Loss
–X
+Z
Z
PW
Y
Domestic
demand
QS
QA
QD
Quantity of
phones
Imports
When the domestic price falls to PW as a result of international trade, consumers gain additional surplus (areas X +
Z) and producers lose surplus (area X). Because the gains
to consumers outweigh the losses to producers, there is
an increase in the total surplus in the economy as a whole
(area Z).
However, we have also learned that although the country as a whole gains, some
groups—in this case, domestic producers of phones—lose as a result of international trade. As we’ll see shortly, the fact that international trade typically creates
losers as well as winners is crucial for understanding the politics of trade policy.
We turn next to the case in which a country exports a good.
The Effects of Exports
Figure 5-8 shows the effects on a country when it exports a good, in this case
trucks. For this example, we assume that unlimited quantities of trucks can be
sold abroad at a given world price, PW, which is higher than the price that would
prevail in the domestic market in autarky, PA.
The higher world price makes it profitable for exporters to buy trucks domestically and sell them overseas. The purchases of domestic trucks drive the domestic
price up until it is equal to the world price. As a result, the quantity demanded by
domestic consumers falls from QA to QD and the quantity supplied by domestic
producers rises from QA to QS. This difference between domestic production and
domestic consumption, QS − QD, is exported.
Like imports, exports lead to an overall gain in total surplus for the exporting
country but also create losers as well as winners. Figure 5-9 shows the effects of
truck exports on producer and consumer surplus. In the absence of trade, the
price of each truck would be PA. Consumer surplus in the absence of trade is the
sum of areas W and X, and producer surplus is area Y. As a result of trade, price
rises from PA to PW, consumer surplus falls to W, and producer surplus rises to
Y + X + Z. So producers gain X + Z, consumers lose X, and, as shown in the table
accompanying the figure, the economy as a whole gains total surplus in the
amount of Z.
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The Domestic Market with Exports
FIGURE 5-8
Here the world price, PW , is greater
than the autarky price, PA . When the
economy is opened to international
trade, some of the domestic supply
is now exported. The domestic price
rises from the autarky price, PA , to
the world price, PW . As the price
rises, the domestic quantity demanded falls from Q A to QD and the
domestic quantity supplied rises from
Q A to QS . The portion of domestic
production that is not consumed
domestically, QS − QD , is exported.
Price of
truck
Domestic
supply
World price
PW
A
PA
Autarky price
Domestic
demand
Domestic
quantity
demanded
with trade
QD
QA
QS
Exports
Domestic
quantity
supplied
with trade
Quantity
of trucks
We have learned, then, that imports of a particular good hurt domestic producers of that good but help domestic consumers, whereas exports of a particular
good hurt domestic consumers of that good but help domestic producers. In each
case, the gains are larger than the losses.
The Effects of Exports on Surplus
FIGURE 5-9
Price of
truck
Changes in surplus
Domestic
supply
W
PW
PA
Z
X
A
Gain
Consumer surplus
Loss
–X
Producer surplus
X+Z
Change in
total surplus
+Z
Y
Domestic
demand
QD
QA
QS
Quantity
of trucks
Exports
When the domestic price rises to PW as a result of trade,
producers gain additional surplus (areas X + Z) but consumers lose surplus (area X). Because the gains to producers
outweigh the losses to consumers, there is an increase in the
total surplus in the economy as a whole (area Z).
145
146 P A R T 2
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International Trade and Wages
Exporting industries produce
goods and services that are sold
abroad.
Import-competing industries
produce goods and services that are
also imported.
So far we have focused on the effects of international trade on producers and
consumers in a particular industry. For many purposes this is a very helpful
approach. However, producers and consumers are not the only parts of society
affected by trade—so are the owners of factors of production. In particular, the
owners of labor, land, and capital employed in producing goods that are exported,
or goods that compete with imported goods, can be deeply affected by trade.
Moreover, the effects of trade aren’t limited to just those industries that export
or compete with imports because factors of production can often move between
industries. So now we turn our attention to the long-run effects of international
trade on income distribution—how a country’s total income is allocated among
its various factors of production.
To begin our analysis, consider the position of Maria, an accountant at West
Coast Phone Production, Inc. If the economy is opened up to imports of phones
from China, the domestic phone industry will contract, and it will hire fewer
accountants. But accounting is a profession with employment opportunities in
many industries, and Maria might well find a better job in the automobile industry, which expands as a result of international trade. So it may not be appropriate
to think of her as a producer of phones who is hurt by competition from imported
parts. Rather, we should think of her as an accountant who is affected by phone
imports only to the extent that these imports change the wages of accountants in
the economy as a whole.
The wage rate of accountants is a factor price—the price employers have to pay
for the services of a factor of production. One key question about international
trade is how it affects factor prices—not just narrowly defined factors of production like accountants, but broadly defined factors such as capital, unskilled labor,
and college-educated labor.
Earlier in this chapter we described the Heckscher–Ohlin model of trade,
which states that comparative advantage is determined by a country’s factor
endowment. This model also suggests how international trade affects factor
prices in a country: compared to autarky, international trade tends to raise the
prices of factors that are abundantly available and reduce the prices of factors
that are scarce.
We won’t work this out in detail, but the idea is simple. The prices of factors
of production, like the prices of goods and services, are determined by supply and
demand. If international trade increases the demand for a factor of production,
that factor’s price will rise; if international trade reduces the demand for a factor
of production, that factor’s price will fall.
Now think of a country’s industries as consisting of two kinds: exporting industries, which produce goods and services that are sold abroad, and
import-competing industries, which produce goods and services that are
also imported from abroad. Compared with autarky, international trade leads
to higher production in exporting industries and lower production in importcompeting industries. This indirectly increases the demand for factors used
by exporting industries and decreases the demand for factors used by importcompeting industries.
In addition, the Heckscher–Ohlin model says that a country tends to export
goods that are intensive in its abundant factors and to import goods that are
intensive in its scarce factors. So international trade tends to increase the demand
for factors that are abundant in our country compared with other countries, and to
decrease the demand for factors that are scarce in our country compared with other
countries. As a result, the prices of abundant factors tend to rise, and the prices of
scarce factors tend to fall as international trade grows.
In other words, international trade tends to redistribute income toward a
country’s abundant factors and away from its less abundant factors.
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147
U.S. exports tend to be human-capital-intensive (such as high-tech design and
Hollywood movies) while U.S. imports tend to be unskilled-labor-intensive (such
as phone assembly and clothing production). This suggests that the effect of international trade on the U.S. factor markets is to raise the wage rate of highly educated American workers and reduce the wage rate of unskilled American workers.
This effect has been a source of much concern in recent years. Wage
inequality—the gap between the wages of high-paid and low-paid workers—has
increased substantially over the last 30 years. Some economists believe that
growing international trade is an important factor in that trend. If international
trade has the effects predicted by the Heckscher–Ohlin model, its growth raises
the wages of highly educated American workers, who already have relatively high
wages, and lowers the wages of less educated American workers, who already
have relatively low wages. But keep in mind another phenomenon: trade reduces
the income inequality between countries as poor countries improve their standard of living by exporting to rich countries.
How important are these effects? In some historical episodes, the impacts of
international trade on factor prices have been very large. As we explain in the
following Economics in Action, the opening of transatlantic trade in the late
nineteenth century had a large negative impact on land rents in Europe, hurting
landowners but helping workers and owners of capital.
The effects of trade on wages in the United States have generated considerable
controversy in recent years. Most economists who have studied the issue agree
that growing imports of labor-intensive products from newly industrializing
economies, and the export of high-technology goods in return, have helped cause
a widening wage gap between highly educated and less educated workers in this
country. However, most economists believe that it is only one of several forces
explaining the growth in American wage inequality.
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TRADE, WAGES, AND LAND PRICES IN THE
NINETEENTH CENTURY
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eginning around 1870, there was an explosive growth of world trade in agricultural products, based largely on the steam
engine. Steam-powered ships could cross the
ocean much more quickly and reliably than
sailing ships. Until about 1860, steamships had
higher costs than sailing ships, but after that
costs dropped sharply. At the same time, steampowered rail transport made it possible to bring
grain and other bulk goods cheaply from the interior to ports. The result was that land-abundant
countries—the United States, Canada, Argentina,
and Australia—began shipping large quantities of
agricultural goods to the densely populated, landscarce countries of Europe.
This opening up of international trade led to
higher prices of agricultural products, such as
wheat, in exporting countries and a decline in
their prices in importing countries. Notably, the
difference between wheat prices in the midwestern
United States and England plunged.
International trade redistributes income toward a country’s abundant
factors and away from its less abundant factors.
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Quick Review
• The intersection of the
domestic demand curve and
the domestic supply curve
determines the domestic price of a
good. When a market is opened to
international trade, the domestic
price is driven to equal the world
price.
• If the world price is lower than
the autarky price, trade leads to
imports and the domestic price
falls to the world price. There are
overall gains from international
trade because the gain in
consumer surplus exceeds the loss
in producer surplus.
• If the world price is higher than
the autarky price, trade leads to
exports and the domestic price
rises to the world price. There are
overall gains from international
trade because the gain in producer
surplus exceeds the loss in
consumer surplus.
• Trade leads to an expansion
of exporting industries,
which increases demand for a
country’s abundant factors, and a
contraction of import-competing
industries, which decreases
demand for its scarce factors.
The change in agricultural prices created winners and losers on both sides of
the Atlantic as factor prices adjusted. In England, land prices fell by half compared
with average wages; landowners found their purchasing power sharply reduced,
but workers benefited from cheaper food. In the United States, the reverse happened: land prices doubled compared with wages. Landowners did very well, but
workers found the purchasing power of their wages dented by rising food prices.
Check Your Understanding
5-2
1.Due to a strike by truckers, trade in food between the United States and Mexico is
halted. In autarky, the price of Mexican grapes is lower than that of U.S. grapes.
Using a diagram of the U.S. domestic demand curve and the U.S. domestic supply
curve for grapes, explain the effect of the strike on the following.
a. U.S. grape consumers’ surplus
b. U.S. grape producers’ surplus
c. U.S. total surplus
2.What effect do you think the strike will have on Mexican grape producers? Mexican
grape pickers? Mexican grape consumers? U.S. grape pickers?
Solutions appear at back of book.
The Effects of Trade Protection
Ever since David Ricardo laid out the principle of comparative advantage in the
early nineteenth century, most economists have advocated free trade. That is,
they have argued that government policy should not attempt either to reduce or
to increase the levels of exports and imports that occur naturally as a result of
supply and demand.
Despite the free-trade arguments of economists, however, many governments
use taxes and other restrictions to limit imports. Less frequently, governments
offer subsidies to encourage exports. Policies that limit imports, usually with the
goal of protecting domestic producers in import-competing industries from foreign competition, are known as trade protection or simply as protection.
Let’s look at the two most common protectionist policies, tariffs and import
quotas, then turn to the reasons governments follow these policies.
The Effects of a Tariff
An economy has free trade when
the government does not attempt
either to reduce or to increase the
levels of exports and imports that
occur naturally as a result of supply
and demand.
Policies that limit imports are known
as trade protection or simply as
protection.
A tariff is a tax levied on imports.
A tariff is a form of excise tax, one that is levied only on sales of imported
goods. For example, the U.S. government could declare that anyone bringing
in phones must pay a tariff of $100 per unit. In the distant past, tariffs were
an important source of government revenue because they were relatively easy
to collect. But in the modern world, tariffs are usually intended to discourage
imports and protect import-competing domestic producers rather than as a
source of government revenue.
The tariff raises both the price received by domestic producers and the price
paid by domestic consumers. Suppose, for example, that our country imports
phones, and a phone costs $200 on the world market. As we saw earlier, under
free trade the domestic price would also be $200. But if a tariff of $100 per unit
is imposed, the domestic price will rise to $300, because it won’t be profitable to
import phones unless the price in the domestic market is high enough to compensate importers for the cost of paying the tariff.
Figure 5-10 illustrates the effects of a tariff on imports of phones. As before,
we assume that PW is the world price of a phone. Before the tariff is imposed,
imports have driven the domestic price down to PW, so that pre-tariff domestic
production is QS, pre-tariff domestic consumption is QD, and pre-tariff imports
are QD − QS.
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FIGURE 5-10
I N T E R N AT I O N A L T R A D E
The Effect of a Tariff
A tariff raises the domestic price of
the good from P W to P T. The domestic quantity demanded shrinks from
Q D to Q DT , and the domestic quantity supplied increases from QS to
QST . As a result, imports—which had
been QD − QS before the tariff was
imposed—shrink to QDT − QST after
the tariff is imposed.
Price of
phone
Domestic
supply
Price with
tariff
PT
Tariff
PW
Domestic
demand
World price
Imports
after tariff
QS
QST
QDT
Imports before tariff
Now suppose that the government imposes a tariff on each phone imported.
As a consequence, it is no longer profitable to import phones unless the domestic
price received by the importer is greater than or equal to the world price plus the
tariff. So the domestic price rises to PT, which is equal to the world price, PW, plus
the tariff. Domestic production rises to QST, domestic consumption falls to QDT,
and imports fall to QDT − QST.
A tariff, then, raises domestic prices, leading to increased domestic production and reduced domestic consumption compared to the situation under free
trade. Figure 5-11 shows the effects on surplus. There are three effects:
1. The higher domestic price increases producer surplus, a gain equal to area A.
2. The higher domestic price reduces consumer surplus, a reduction equal to the
sum of areas A, B, C, and D.
3. The tariff yields revenue to the government. How much revenue? The govern-
ment collects the tariff—which, remember, is equal to the difference between
PT and PW on each of the QDT − QST units imported. So total revenue is (PT − PW)
× (QDT − QST). This is equal to area C.
The welfare effects of a tariff are summarized in the table in Figure 5-11.
Producers gain, consumers lose, and the government gains. But consumer losses
are greater than the sum of producer and government gains, leading to a net
reduction in total surplus equal to areas B + D.
An excise tax creates inefficiency, or deadweight loss, because it prevents mutually
beneficial trades from occurring. The same is true of a tariff, where the deadweight
loss imposed on society is equal to the loss in total surplus represented by areas B + D.
Tariffs generate deadweight losses because they create inefficiencies in two ways:
1. Some mutually beneficial trades go unexploited: some consumers who are
willing to pay more than the world price, PW, do not purchase the good, even
though PW is the true cost of a unit of the good to the economy. The cost of this
inefficiency is represented in Figure 5-11 by area D.
QD Quantity
of phones
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150 P A R T 2
S U P P LY A N D D E M A N D
FIGURE 5-11
A Tariff Reduces Total Surplus
Price of
phone
Changes in surplus
Domestic
supply
Consumer surplus
A
C
B
Loss
–(A + B + C + D)
Producer surplus
A
Government revenue
C
Change in
total surplus
PT
Tariff
Gain
–(B + D)
D
PW
Domestic
demand
Imports
after tariff
QS
QST
QDT
QD
Quantity
of phones
Imports before tariff
When the domestic price rises as a result of a tariff, producers gain additional surplus (area A), the government
gains revenue (area C), and consumers lose surplus
(areas A + B + C + D). Because the losses to consumers
outweigh the gains to producers and the government, the
economy as a whole loses surplus (areas B + D).
2. The economy’s resources are wasted on inefficient production: some produc-
ers whose cost exceeds PW produce the good, even though an additional unit
of the good can be purchased abroad for PW. The cost of this inefficiency is
represented in Figure 5-11 by area B.
The Effects of an Import Quota
An import quota is a legal limit on
the quantity of a good that can be
imported.
An import quota, another form of trade protection, is a legal limit on the quantity
of a good that can be imported. For example, a U.S. import quota on Chinese phones
might limit the quantity imported each year to 50 million units. Import quotas are
usually administered through licenses: a number of licenses are issued, each giving
the license-holder the right to import a limited quantity of the good each year.
A quota on sales has the same effect as an excise tax, with one difference:
the money that would otherwise have accrued to the government as tax revenue
under an excise tax becomes license-holders’ revenue under a quota—also known
as quota rents. (Quota rent was defined in Chapter 4.) Similarly, an import quota
has the same effect as a tariff, with one difference: the money that would otherwise have been government revenue becomes quota rents to license-holders. Look
again at Figure 5-11. An import quota that limits imports to QDT − QST will raise
the domestic price of phones by the same amount as the tariff we considered
previously. That is, it will raise the domestic price from PW to PT. However, area C
will now represent quota rents rather than government revenue.
Who receives import licenses and so collects the quota rents? In the case of
U.S. import protection, the answer may surprise you: the most important import
licenses—mainly for clothing, and to a lesser extent for sugar—are granted to
foreign governments.
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151
Because the quota rents for most U.S. import quotas go to foreigners, the cost
to the nation of such quotas is larger than that of a comparable tariff (a tariff
that leads to the same level of imports). In Figure 5-11 the net loss to the United
States from such an import quota would be equal to areas B + C + D, the difference between consumer losses and producer gains.
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Trade Protection in The United States
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Check Your Understanding
5-3
1.Suppose the world price of butter is $0.50 per pound and the domestic price in
autarky is $1.00 per pound. Use a diagram similar to Figure 5-10 to show the
following.
a. If there is free trade, domestic butter producers want the government to impose
a tariff of no less than $0.50 per pound. Compare the outcome with a tariff of
$0.25 per pound.
b. What happens if a tariff greater than $0.50 per pound is imposed?
2.Suppose the government imposes an import quota rather than a tariff on butter.
What quota limit would generate the same quantity of imports as a tariff of $0.50
per pound?
Solutions appear at back of book.
13
11
20
09
20
20
07
20
04
20
02
20
99
95
19
19
19
93
he United States today generally folTariff Rates and Estimated Welfare
FIGURE 5-12
lows a policy of free trade, both
Losses, 1993–2013
in comparison with other countries
and in comparison with its own history.
Welfare loss
Average import
(% of GDP)
tariff (%)
Most imports are subject to either no tariff
or to a low tariff. So what are the major
4.0%
0.30%
Average import tariff
exceptions to this rule?
3.5
0.25
Most of the remaining protection
3.0
involves agricultural products. Topping the
0.20
2.5
list is ethanol, which in the United States
2.0
0.15
is mainly produced from corn and used as
1.5
an ingredient in motor fuel. Most imported
0.10
ethanol is subject to a fairly high tariff, but
1.0
Welfare gain
0.05
some countries are allowed to sell a limited
0.5
amount of ethanol in the United States,
0
0
at high prices, without paying the tariff.
Dairy products also receive substantial
Year of report
import protection, again through a combiSources: U.S. International Trade Commission (2013), Federal Reserve Bank of St. Louis;
nation of tariffs and quotas.
and World Development Indicators.
Until a few years ago, clothing and
textiles were also strongly protected from
import competition, thanks to an elaborate system of import quotas. However,
Quick Review
this system was phased out in 2005 as part of a trade agreement reached a decade
• Most economists advocate
earlier. Some clothing imports are still subject to relatively high tariffs, but profree trade, although many
tection in the clothing industry is a shadow of what it used to be.
governments engage in trade
The most important thing to know about current U.S. trade protection is how
protection of import-competing
limited it really is, and how little cost it imposes on the economy. Every two years
industries. The two most common
the U.S. International Trade Commission, a government agency, produces estiprotectionist policies are tariffs
mates of the impact of “significant trade restrictions” on U.S. welfare. As Figure
and import quotas. In rare
5-12 shows, over the past two decades both average tariff levels and the cost of
instances, governments subsidize
exporting industries.
trade restrictions as a share of national income, which weren’t all that big to
begin with, have fallen sharply.
• A tariff is a tax on imports. It
raises the domestic price above
the world price, leading to a fall in
trade and domestic consumption
and a rise in domestic production.
Domestic producers and the
government gain, but domestic
consumer losses more than offset
this gain, leading to deadweight
loss.
• An import quota is a legal
quantity limit on imports. Its
effect is like that of a tariff, except
that revenues—the quota rents—
accrue to the license holder, not to
the domestic government.
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S U P P LY A N D D E M A N D
The Political Economy of Trade Protection
We have seen that international trade produces mutual benefits to the countries
that engage in it. We have also seen that tariffs and import quotas, although they
produce winners as well as losers, reduce total surplus. Yet many countries continue to impose tariffs and import quotas as well as to enact other protectionist
measures.
To understand why trade protection takes place, we will first look at some
common justifications for protection. Then we will look at the politics of trade
protection. Finally, we will look at an important feature of trade protection in
today’s world: tariffs and import quotas are the subject of international negotiation and are policed by international organizations.
Arguments for Trade Protection
Advocates for tariffs and import quotas offer a variety of arguments. Three common arguments are national security, job creation, and the infant industry argument.
The national security argument is based on the proposition that overseas
sources of goods are vulnerable to disruption in times of international conflict;
therefore, a country should protect domestic suppliers of crucial goods with the
aim to be self-sufficient in those goods. In the 1960s, the United States—which
had begun to import oil as domestic oil reserves ran low—had an import quota
on oil, justified on national security grounds. Some people have argued that
we should again have policies to discourage imports of oil, especially from the
Middle East.
The job creation argument points to the additional jobs created in importcompeting industries as a result of trade protection. Economists argue that these
jobs are offset by the jobs lost elsewhere, such as industries that use imported
inputs and now face higher input costs. But noneconomists don’t always find this
argument persuasive.
Finally, the infant industry argument, often raised in newly industrializing
countries, holds that new industries require a temporary period of trade protection to get established. For example, in the 1950s many countries in Latin
America imposed tariffs and import quotas on manufactured goods, in an effort
to switch from their traditional role as exporters of raw materials to a new status
as industrial countries.
In theory, the argument for infant industry protection can be compelling,
particularly in high-tech industries that increase a country’s overall skill level.
Reality, however, is more complicated: it is most often industries that are politically influential that gain protection. In addition, governments tend to be poor
predictors of the best emerging technologies. Finally, it is often very difficult to
wean an industry from protection when it should be mature enough to stand on
its own.
The Politics of Trade Protection
In reality, much trade protection has little to do with the arguments just described.
Instead, it reflects the political influence of import-competing producers.
We’ve seen that a tariff or import quota leads to gains for import-competing
producers and losses for consumers. Producers, however, usually have much
more influence over trade policy decisions. The producers who compete with
imports of a particular good are usually a smaller, more cohesive group than the
consumers of that good.
An example is trade protection for sugar: the United States has an import
quota on sugar, which on average leads to a domestic price about twice the world
price. This quota is difficult to rationalize in terms of any economic argument.
However, consumers rarely complain about the quota because they are unaware
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that it exists: because no individual consumer buys large amounts of sugar, the
cost of the quota is only a few dollars per family each year, not enough to attract
notice. But there are only a few thousand sugar growers in the United States. They
are very aware of the benefits they receive from the quota and make sure that their
representatives in Congress are also aware of their interest in the matter.
Given these political realities, it may seem surprising that trade is as free as
it is. For example, the United States has low tariffs, and its import quotas are
mainly confined to clothing and a few agricultural products. It would be nice to
say that the main reason trade protection is so limited is that economists have
convinced governments of the virtues of free trade. A more important reason,
however, is the role of international trade agreements.
International Trade Agreements and
the World Trade Organization
When a country engages in trade protection, it hurts two groups. We’ve already
emphasized the adverse effect on domestic consumers, but protection also hurts
foreign export industries. This means that countries care about one anothers’
trade policies: the Canadian lumber industry, for example, has a strong interest
in keeping U.S. tariffs on forest products low.
Because countries care about one anothers’ trade policies, they enter into
international trade agreements: treaties in which a country promises to engage
in less trade protection against the exports of another country in return for a
promise by the other country to do the same for its own exports. Most world trade
is now governed by such agreements.
Some international trade agreements involve just two countries or a small group
of countries. The United States, Canada, and Mexico are joined together by the
North American Free Trade Agreement, or NAFTA. This agreement was signed
in 1993, and by 2008 it had removed all barriers to trade among the three nations.
In Europe, 28 nations are part of an even more comprehensive agreement, the
European Union, or EU. In NAFTA, the member countries set their own tariff
rates against imports from other nonmember countries. The EU, however, is a
customs union: tariffs are levied at the same rate on goods from outside the EU
entering the union.
There are also global trade agreements covering most of the world. Such
global agreements are overseen by the World Trade Organization, or WTO,
an international organization composed of member countries, which plays
two roles. First, it provides the framework for the massively complex negotiations involved in a major international trade agreement (the full text of the last
major agreement, approved in 1994, was 24,000 pages long). Second, the WTO
resolves disputes between its members. These disputes typically arise when
one country claims that another country’s policies violate its previous agreements. Currently, the WTO has 160 member countries, accounting for the bulk
of world trade.
Here are two examples that illustrate the WTO’s role. First, in 1992 a trade
dispute broke out over the European Union’s import restrictions on bananas,
which gave preference to producers in former European colonies over producers from Central America. In 1999 the WTO ruled that these restrictions were
in violation of international trade rules. The United States took the side of the
Central American countries, and the dispute became a major source of trade conflict between the European Union and the United States, known as the “banana
wars.” In 2012, twenty years after the dispute began, the European Union finally
changed its import regulations to abide by the WTO ruling.
A more recent example is the dispute between the United States and Brazil
over American subsidies to its cotton farmers. These subsidies, in the amount
of $3 billion to $4 billion a year, are illegal under WTO rules. Brazil argues
I N T E R N AT I O N A L T R A D E
153
International trade agreements
are treaties in which a country
promises to engage in less trade
protection against the exports
of other countries in return for a
promise by other countries to do the
same for its own exports.
The North American Free Trade
Agreement, or NAFTA, is a a trade
agreement among the United States,
Canada, and Mexico.
The European Union, or EU, is a
customs union among 28 European
nations.
The World Trade Organization, or
WTO, oversees international trade
agreements and rules on disputes
between countries over those
agreements.
S U P P LY A N D D E M A N D
In September 2009 the U.S. government
imposed steep tariffs on imports of tires
from China. The tariffs were imposed for
three years: 35% in the first year, 30%
in the second, and 25% in the third.
The tariffs were a response to union
complaints about the effects of surging
Chinese tire exports: between 2004 and
2008, U.S. imports of automobile tires
from China had gone from 15 million
to 46 million, and labor groups warned
that this was costing American jobs.
The unions wanted an import quota, but
getting the tariff was still a political vic-
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tory for organized labor. But wasn’t the
tariff a violation of WTO rules? No, said
the Obama administration. When China
joined the WTO in 2001, it agreed to
what is known, in trade policy jargon,
as a “safeguard mechanism”: importing countries were granted the right to
impose temporary limits on Chinese
exports in the event of an import surge.
Despite this agreement, the government
of China protested the U.S. action and
appealed to the WTO to rule the tariff
illegal. But in December 2010 the WTO
came down on America’s side, ruling
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Tires Under Pressure
FOR INQUIRING MINDS
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154 P A R T 2
that the Obama administration had been
within its rights.
You shouldn’t be too cynical about
this failure to achieve complete free
trade in tires. World trade negotiations
have always been based on the principle
that half a loaf is better than none, that
it’s better to have an agreement that
allows politically sensitive industries to
retain some protection than to insist on
free-trade purity. In spite of such actions
as the tire tariff, world trade is, on the
whole, remarkably free, and freer in many
ways than it was just a few years ago.
•
that they artificially reduce the price of American cotton on world markets and
hurt Brazilian cotton farmers. In 2005 the WTO ruled against the United States
and in favor of Brazil, and the United States responded by cutting some export
subsidies on cotton. However, in 2007 the WTO ruled that the United States
had not done enough to fully comply, such as eliminating government loans to
cotton farmers. After Brazil threatened, in turn, to impose import tariffs on
U.S.-manufactured goods, in 2010 the two sides agreed to a framework for the
solution to the cotton dispute.
Both Vietnam and Thailand are members of the WTO. Yet the United States
has, on and off, imposed tariffs on shrimp imports from these countries. The
reason this is possible is that WTO rules do allow trade protection under certain
circumstances. One circumstance is where the foreign competition is “unfair”
under certain technical criteria. Trade protection is also allowed as a temporary
measure when a sudden surge of imports threatens to disrupt a domestic industry. The response to Chinese tire exports, described in the accompanying For
Inquiring Minds, is an important recent example.
The WTO is sometimes, with great exaggeration, described as a world government. In fact, it has no army, no police, and no direct enforcement power. The
grain of truth in that description is that when a country joins the WTO, it agrees
to accept the organization’s judgments—and these judgments apply not only to
tariffs and import quotas but also to domestic policies that the organization considers trade protection disguised under another name. So in joining the WTO a
country does give up some of its sovereignty.
Challenges to Globalization
The forward march of globalization over the past century is generally considered a major political and economic success. Economists and policy makers
alike have viewed growing world trade, in particular, as a good thing. We
would be remiss, however, if we failed to acknowledge that many people are
having second thoughts about globalization. To a large extent, these second
thoughts reflect two concerns shared by many economists: worries about the
effects of globalization on inequality and worries that new developments,
in particular the growth in offshore outsourcing, are increasing economic
insecurity.
Globalization and Inequality We’ve already mentioned the implications of
international trade for factor prices, such as wages: when wealthy countries
CHAPTER 5
like the United States export skill-intensive products like aircraft while importing labor-intensive products like clothing, they can expect to see the wage gap
between more educated and less educated domestic workers widen. Forty years
ago, this wasn’t a significant concern, because most of the goods wealthy countries imported from poorer countries were raw materials or goods where comparative advantage depended on climate. Today, however, many manufactured
goods are imported from relatively poor countries, with a potentially much larger
effect on the distribution of income.
Trade with China, in particular, raises concerns among labor groups trying to maintain wage levels in rich countries. Although China has experienced
spectacular economic growth since the economic reforms that began in the late
1970s, it remains a poor, low-wage country: wages in Chinese manufacturing are
estimated to be only about 5% of U.S. wages. Meanwhile, imports from China
have soared. In 1983 less than 1% of U.S. imports came from China; by 2013, the
figure was more than 16%. There’s not much question that these surging imports
from China put at least some downward pressure on the wages of less educated
American workers.
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155
Offshore outsourcing takes place
when businesses hire people in
another country to perform various
tasks.
labor-intensive manufactured goods. However, some U.S. workers have recently
found themselves facing a new form of international competition. Outsourcing,
in which a company hires another company to perform some task, such as running the corporate computer system, is a long-standing business practice. Until
recently, however, outsourcing was normally done locally, with a company hiring
another company in the same city or country.
Now, modern telecommunications increasingly make it possible to engage in
offshore outsourcing, in which businesses hire people in another country to
perform various tasks. The classic example is call centers: the person answering
the phone when you call a company’s 1-800 help line may well be in India, which
has taken the lead in attracting offshore outsourcing. Offshore outsourcing has
also spread to fields such as software design and even health care: the radiologist examining your X-rays, like the person giving you computer help, may be on
another continent.
Although offshore outsourcing has come as a shock to some
U.S. workers, such as programmers whose jobs have been outsourced to India, it’s still relatively small compared with more
traditional trade. Some economists have warned, however, that
millions or even tens of millions of workers who have never
thought they could face foreign competition for their jobs may
face unpleasant surprises in the not-too-distant future.
Concerns about income distribution and outsourcing, as
we’ve said, are shared by many economists. There is also,
however, widespread opposition to globalization in general,
particularly among college students. In 1999, an attempt
to start a major round of trade negotiations failed in part
because the WTO meeting, in Seattle, was disrupted by antiOffshore outsourcing has the potential to disrupt the job
globalization demonstrators. However, the more important
prospects of millions of U.S. workers.
reason for its failure was disagreement among the countries
represented. Another round of negotiations that began in
2001 in Doha, Qatar, and is therefore referred to as the “Doha development
round.” By 2008 it had stalled, mainly due to disagreements over agricultural
trade rules. As of 2014 there was little sign of progress although the round was
still being officially negotiated.
What motivates the antiglobalization movement? To some extent it’s the sweatshop labor fallacy: it’s easy to get outraged about the low wages paid to the person
Terry Vine/Getty Images
Outsourcing Chinese exports to the United States overwhelmingly consist of
156 P A R T 2
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who made your shirt, and harder to appreciate how much worse off that person
would be if denied the opportunity to sell goods in rich countries’ markets. It’s
also true, however, that the movement represents a backlash against supporters of globalization who have oversold its benefits. Countries in Latin America,
in particular, were promised that reducing their tariff rates would produce an
economic takeoff; instead, they have experienced disappointing results. Some
groups, such as poor farmers facing new competition from imported food, ended
up worse off.
Do these new challenges to globalization undermine the argument that international trade is a good thing? The great majority of economists would argue that
the gains from reducing trade protection still exceed the losses. However, it has
become more important than before to make sure that the gains from international trade are widely spread. And the politics of international trade are becoming increasingly difficult as the extent of trade has grown.
Beefing Up Exports
Kyodo via AP Images
I
n December 2010, negotiators from the United States and
South Korea reached final agreement on a free-trade deal
that would phase out many of the tariffs and other restrictions on trade between the two nations. The deal also involved
changes in a variety of business regulations that were expected
to make it easier for U.S. companies to operate in South Korea.
This was, literally, a fairly big deal: South Korea’s economy is
comparable in size to Mexico’s, so this was the most important
free-trade agreement that the United States had been party to
since NAFTA.
What made this deal possible? Estimates by the U.S.
International Trade Commission found that the deal would raise
average American incomes, although modestly: the commission
put the gains at around one-tenth of one percent. Not bad when
you consider the fact that South Korea, despite its relatively large
economy, is still only America’s seventh-most-important trading
partner.
These overall gains played little role in the politics of the deal,
The 2010 trade agreement between South Korea and
however,
which hinged on losses and gains for particular U.S.
the United States was the most important free-trade
constituencies.
Some opposition to the deal came from labor, espedeal since NAFTA and a boon for the U.S. beef industry.
cially from autoworkers, who feared that eliminating the 8% U.S.
tariff on imports of Korean automobiles would lead to job losses. But there were
also interest groups in America that badly wanted the deal, most notably the beef
industry: Koreans are big beefeaters, yet American access to that market was
limited by a 38% Korean tariff.
And the Obama administration definitely wanted a deal, in part for reasons
unrelated to economics: South Korea is an important U.S. ally, and military
tensions with North Korea were ratcheting up even as the final negotiations
were taking place. So a trade deal was viewed in part as a symbol of U.S.–South
Korean cooperation. Even labor unions weren’t as opposed as they might have
been; the administration’s imposition of tariffs on Chinese tires, just described in
For Inquiring Minds, was seen as a demonstration that it was prepared to defend
labor interests.
It also helped that South Korea—unlike Mexico when NAFTA was signed—is
both a fairly high-wage country and not right on the U.S. border, which meant
less concern about massive shifts of manufacturing. In the end, the balance of
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interests was just favorable enough to make the deal politically possible. The deal
went into effect on March 15, 2012.
Check Your Understanding
5-4
1.In 2002 the United States imposed tariffs on steel imports, which are an input
in a large number and variety of U.S. industries. Explain why political lobbying
to eliminate these tariffs is more likely to be effective than political lobbying to
eliminate tariffs on consumer goods such as sugar or clothing.
2.Over the years, the WTO has increasingly found itself adjudicating trade disputes
that involve not just tariffs or quota restrictions but also restrictions based on quality, health, and environmental considerations. Why do you think this has occurred?
What method would you, as a WTO official, use to decide whether a quality, health,
or environmental restriction is in violation of a free-trade agreement?
Solutions appear at back of book.
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157
Quick Review
• The three major justifications
for trade protection are national
security, job creation, and
protection of infant industries.
• Despite the deadweight
losses, import protections are
often imposed because groups
representing import-competing
industries are more influential
than groups of consumers.
• To further trade liberalization,
countries engage in international
trade agreements. Some
agreements are among a small
number of countries, such as the
North American Free Trade
Agreement (NAFTA) and the
European Union (EU). The
World Trade Organization
(WTO) seeks to negotiate global
trade agreements and referee
trade disputes between members.
• Resistance to globalization
has emerged in response to a
surge in imports from relatively
poor countries and the offshore
outsourcing of many jobs that
had been considered safe from
foreign competition.
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Li & Fung: From Guangzhou to You
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Jerome Favre/Bloomberg via Getty Images
t’s a very good bet that as you read this, you’re wearing something manufactured in Asia. And if you are, it’s also a good bet that the Hong Kong company
Li & Fung was involved in getting your garment designed, produced, and
shipped to your local store. From Levi’s to The Limited to Walmart, Li & Fung is a
critical conduit from factories around the world to the shopping mall nearest you.
The company was founded in 1906 in Guangzhou, China. According to Victor
Fung, the company’s chairman, his grandfather’s “value added” was
that he spoke English, allowing him to serve as an interpreter in business deals between Chinese and foreigners. When Mao’s Communist
Party seized control in mainland China, the company moved to Hong
Kong. There, as Hong Kong’s market economy took off during the
1960s and 1970s, Li & Fung grew as an export broker, bringing together Hong Kong manufacturers and foreign buyers.
The real transformation of the company came, however, as Asian
economies grew and changed. Hong Kong’s rapid growth led to rising
wages, making Li & Fung increasingly uncompetitive in garments, its
main business. So the company reinvented itself: rather than being a
simple broker, it became a “supply chain manager.” Not only would it
allocate production of a good to a manufacturer, it would also break
production down, allocate production of the inputs, and then allocate
final assembly of the good among its 12,000+ suppliers around the
globe. Sometimes production would be done in sophisticated economies like those
of Hong Kong or even Japan, where wages are high but so is quality and productivity; sometimes it would be done in less advanced locations like mainland China or
Thailand, where labor is less productive but cheaper.
For example, suppose you own a U.S. retail chain and want to sell garmentwashed blue jeans. Rather than simply arrange for production of the jeans, Li &
Fung will work with you on their design, providing you with the latest production
and style information, like what materials and colors are hot. After the design has
been finalized, Li & Fung will arrange for the creation of a prototype, find the most
cost-effective way to manufacture it, and then place an order on your behalf. Through
Li & Fung, the yarn might be made in Korea and dyed in Taiwan, and the jeans sewn
in Thailand or mainland China. And because production is taking place in so many
locations, Li & Fung provides transport logistics as well as quality control.
Li & Fung has been enormously successful. In 2012 the company had a market
value of approximately $11.5 billion and business turnover of over $20 billion, with
offices and distribution centers in more than 40 countries. Year after year, it has
regularly doubled or tripled its profits.
QUESTIONS FOR THOUGHT
1. Why do you think it was profitable for Li & Fung to go beyond brokering
exports to becoming a supply chain manager, breaking down the production
process and sourcing the inputs from various suppliers across many countries?
2. What principle do you think underlies Li & Fung’s decisions on how to allocate
production of a good’s inputs and its final assembly among various countries?
3. Why do you think a retailer prefers to have Li & Fung arrange international
production of its jeans rather than purchase them directly from a jeans
manufacturer in mainland China?
4. What is the source of Li & Fung’s success? Is it based on human capital, on
ownership of a natural resource, or on ownership of capital?
158
CHAPTER 5
I N T E R N AT I O N A L T R A D E
159
SUMMARY
1. International trade is of growing importance to the
United States and of even greater importance to most
other countries. International trade, like trade among
individuals, arises from comparative advantage: the
opportunity cost of producing an additional unit of a
good is lower in some countries than in others. Goods
and services purchased from abroad are imports;
those sold abroad are exports. Foreign trade, like
other economic linkages between countries, has been
growing rapidly, a phenomenon called globalization.
Hyperglobalization, the phenomenon of extremely
high levels of international trade, has occurred as
advances in communication and transportation technology have allowed supply chains of production to
span the globe.
2. The Ricardian model of international trade assumes
that opportunity costs are constant. It shows that there
are gains from trade: two countries are better off with
trade than in autarky.
3. In practice, comparative advantage reflects differences
between countries in climate, factor endowments, and
technology. The Heckscher–Ohlin model shows how
differences in factor endowments determine comparative advantage: goods differ in factor intensity, and
countries tend to export goods that are intensive in the
factors they have in abundance.
4. The domestic demand curve and the domestic sup-
ply curve determine the price of a good in autarky.
When international trade occurs, the domestic price
is driven to equality with the world price, the price at
which the good is bought and sold abroad.
5. If the world price is below the autarky price, a good
is imported. This leads to an increase in consumer
surplus, a fall in producer surplus, and a gain in total
surplus. If the world price is above the autarky price, a
good is exported. This leads to an increase in producer
surplus, a fall in consumer surplus, and a gain in total
surplus.
6. International trade leads to expansion in exporting
industries and contraction in import-competing
industries. This raises the domestic demand for
abundant factors of production, reduces the demand
for scarce factors, and so affects factor prices, such
as wages.
7. Most economists advocate free trade, but in practice
many governments engage in trade protection. The two
most common forms of protection are tariffs and quotas. In rare occasions, export industries are subsidized.
8. A tariff is a tax levied on imports. It raises the domes-
tic price above the world price, hurting consumers,
benefiting domestic producers, and generating government revenue. As a result, total surplus falls. An
import quota is a legal limit on the quantity of a good
that can be imported. It has the same effects as a tariff, except that the revenue goes not to the government
but to those who receive import licenses.
9. Although several popular arguments have been made in
favor of trade protection, in practice the main reason for
protection is probably political: import-competing industries are well organized and well informed about how
they gain from trade protection, while consumers are
unaware of the costs they pay. Still, U.S. trade is fairly
free, mainly because of the role of international trade
agreements, in which countries agree to reduce trade
protection against one anothers’ exports. The North
American Free Trade Agreement (NAFTA) and the
European Union (EU) cover a small number of countries. In contrast, the World Trade Organization (WTO)
covers a much larger number of countries, accounting
for the bulk of world trade. It oversees trade negotiations
and adjudicates disputes among its members.
10. In the past few years, many concerns have been
raised about the effects of globalization. One issue is
the increase in income inequality due to the surge in
imports from relatively poor countries over the past 20
years. Another concern is the increase in offshore outsourcing, as many jobs that were once considered safe
from foreign competition have been moved abroad.
KEY TERMS
Imports, p. 132
Exports, p. 132
Globalization, p. 132
Hyperglobalization, p. 132
Ricardian model of international trade,
p. 133
Autarky, p. 134
Factor intensity, p. 139
Heckscher–Ohlin model, p. 139
Domestic demand curve, p. 142
Domestic supply curve, p. 142
World price, p. 142
Exporting industries, p. 146
Import-competing industries, p. 146
Free trade, p. 148
Trade protection, p. 148
Protection, p. 148
Tariff, p. 148
Import quota, p. 150
International trade agreements, p. 153
North American Free Trade Agreement
(NAFTA), p. 153
European Union (EU), p. 153
World Trade Organization (WTO),
p. 153
Offshore outsourcing, p. 155
160 P A R T 2
S U P P LY A N D D E M A N D
PROBLEMS
1. Both Canada and the United States produce lumber and
vi.In the drop-down menu “3-digit and 6-digit NAICS
footballs with constant opportunity costs. The United
States can produce either 10 tons of lumber and no footballs, or 1,000 footballs and no lumber, or any combination in between. Canada can produce either 8 tons of
lumber and no footballs, or 400 footballs and no lumber,
or any combination in between.
a. Draw the U.S. and Canadian production possibility
frontiers in two separate diagrams, with footballs on
the horizontal axis and lumber on the vertical axis.
by country,” select the product category you are
interested in, and hit “Go”
b. In autarky, if the United States wants to consume
500 footballs, how much lumber can it consume at
most? Label this point A in your diagram. Similarly,
if Canada wants to consume 1 ton of lumber, how
many footballs can it consume in autarky? Label
this point C in your diagram.
c. Which country has the absolute advantage in lumber
production?
d. Which country has the comparative advantage in
lumber production?
Suppose each country specializes in the good in which
it has the comparative advantage, and there is trade.
e. How many footballs does the United States produce?
How much lumber does Canada produce?
f. Is it possible for the United States to consume 500
footballs and 7 tons of lumber? Label this point B in
your diagram. Is it possible for Canada at the same
time to consume 500 footballs and 1 ton of lumber?
Label this point D in your diagram.
2. For each of the following trade relationships, explain
the likely source of the comparative advantage of each
of the exporting countries.
a. The United States exports software to Venezuela,
and Venezuela exports oil to the United States.
b. The United States exports airplanes to China, and
China exports clothing to the United States.
c. The United States exports wheat to Colombia, and
Colombia exports coffee to the United States.
3. The U.S. Census Bureau keeps statistics on U.S. imports
and exports on its website. The following steps will take
you to the foreign trade statistics. Use them to answer
the questions below.
i.Go to the U.S. Census Bureau’s website at
www.census.gov
ii.Under the heading “Topics” select “Business” and
then select “International Trade” under the section
“Data by Sector” in the left menu bar
iii. At the top of the page, select the tab “Data”
iv. In the left menu bar, select “Country/Product Trade”
v.Under the heading “North American Industry
Classification System (NAICS)-Based,” select
“NAICS web application”
vii.In the drop-down menu “Select 6-digit NAICS,”
select the good or service you are interested in, and
hit “Go”
viii.In the drop-down menus that allow you to select a
month and year, select “December” and “2013,” and
hit “Go”
ix.The right side of the table now shows the import and
export statistics for the entire year 2013.
For the questions below on U.S. imports, use
the column for “Consumption Imports, Customs
Value Basis.”
a. Look up data for U.S. imports of hats and caps: in
step (vi), select “(315) Apparel & Accessories” and in
step (vii), select “(315220) Men’s and Boys’ Cut and
Sew Apparel.” From which country do we import the
most apparel? Which of the three sources of comparative advantage (climate, factor endowments, and
technology) accounts for that country’s comparative
advantage in apparel production?
b. Look up data for U.S. imports of grapes: in step
(vi), select “(111) Agricultural Products” and in
step (vii), select “(111332) Grapes.” From which
country do we import the most grapes? Which
of the three sources of comparative advantage
(climate, factor endowments, and technology)
accounts for that country’s comparative advantage
in grape production?
c. Look up data for U.S. imports of food product
machinery: in step (vi), select “(333) Machinery,
Except Electrical” and in step (vii), select “333241
Food Product Machinery.” From which country do
we import the most food product machinery? Which
of the three sources of comparative advantage (climate, factor endowments, and technology) accounts
for that country’s comparative advantage in food
product machinery?
4. Since 2000, the value of U.S. imports of men’s and boy’s
apparel from China has more than tripled. What prediction does the Heckscher-Ohlin model make about
the wages received by labor in China?
5. Shoes are labor-intensive and satellites are capital-
intensive to produce. The United States has abundant
capital. China has abundant labor. According to the
Heckscher–Ohlin model, which good will China export?
Which good will the United States export? In the United
States, what will happen to the price of labor (the wage)
and to the price of capital?
CHAPTER 5
I N T E R N AT I O N A L T R A D E
161
6. Before the North American Free Trade Agreement
8. The accompanying table shows the U.S. domestic
(NAFTA) gradually eliminated import tariffs on
goods, the autarky price of tomatoes in Mexico was
below the world price and in the United States was
above the world price. Similarly, the autarky price of
poultry in Mexico was above the world price and in
the United States was below the world price. Draw
diagrams with domestic supply and demand curves
for each country and each of the two goods. As a
result of NAFTA, the United States now imports tomatoes from Mexico and the United States now exports
poultry to Mexico. How would you expect the following groups to be affected?
a. Mexican and U.S. consumers of tomatoes. Illustrate
the effect on consumer surplus in your diagram.
demand schedule and domestic supply schedule for
oranges. Suppose that the world price of oranges is
$0.30 per orange.
Price of orange
Quantity of
oranges demanded
(thousands)
Quantity of
oranges supplied
(thousands)
$1.00
2
11
0.90
4
10
0.80
6
9
0.70
8
8
0.60
10
7
0.50
12
6
0.40
14
5
c. Mexican and U.S. tomato workers.
0.30
16
4
d. Mexican and U.S. consumers of poultry. Illustrate
0.20
18
3
b. Mexican and U.S. producers of tomatoes. Illustrate
the effect on producer surplus in your diagram.
the effect on consumer surplus in your diagram.
e. Mexican and U.S. producers of poultry. Illustrate the
effect on producer surplus in your diagram.
f. Mexican and U.S. poultry workers.
7. The accompanying table indicates the U.S. domestic
demand schedule and domestic supply schedule for
commercial jet airplanes. Suppose that the world price
of a commercial jet airplane is $100 million.
a. Draw the U.S. domestic supply curve and domestic
demand curve.
b. With free trade, how many oranges will the United
States import or export?
Suppose that the U.S. government imposes a tariff on
oranges of $0.20 per orange.
c. How many oranges will the United States import or
export after introduction of the tariff?
Price of jet
(millions)
Quantity of jets
demanded
Quantity of jets
supplied
d. In your diagram, shade the gain or loss to the economy
$120
100
1,000
9. The U.S. domestic demand schedule and domestic
110
150
900
100
200
800
90
250
700
80
300
600
70
350
500
supply schedule for oranges was given in Problem 8.
Suppose that the world price of oranges is $0.30. The
United States introduces an import quota of 3,000
oranges and assigns the quota rents to foreign orange
exporters.
a. Draw the domestic demand and supply curves.
60
400
400
b. What will the domestic price of oranges be after
50
450
300
40
500
200
a. In autarky, how many commercial jet airplanes does
the United States produce, and at what price are
they bought and sold?
b. With trade, what will the price for commercial
jet airplanes be? Will the United States import or
export airplanes? How many?
as a whole from the introduction of this tariff.
introduction of the quota?
c. What is the value of the quota rents that foreign
exporters of oranges receive?
10. The accompanying diagram illustrates the U.S. domes-
tic demand curve and domestic supply curve for beef.
Price of
beef
Domestic
supply
PT
PW
A
B
C
D
Domestic
demand
QS
QST
QDT
QD
Quantity of beef
162 P A R T 2
S U P P LY A N D D E M A N D
The world price of beef is PW . The United States currently imposes an import tariff on beef, so the price of
beef is PT . Congress decides to eliminate the tariff. In
terms of the areas marked in the diagram, answer the
following questions.
a. With the elimination of the tariff what is the gain/
loss in consumer surplus?
b. With the elimination of the tariff what is the gain/
loss in producer surplus?
c. With the elimination of the tariff what is the gain/
loss to the government?
d. With the elimination of the tariff what is the gain/
loss to the economy as a whole?
11. As the United States has opened up to trade, it has lost
many of its low-skill manufacturing jobs, but it has
gained jobs in high-skill industries, such as the software industry. Explain whether the United States as a
whole has been made better off by trade.
12. The United States is highly protective of its agricultural
industry, imposing import tariffs, and sometimes quotas, on imports of agricultural goods. This chapter presented three arguments for trade protection. For each
argument, discuss whether it is a valid justification for
trade protection of U.S. agricultural products.
13. In World Trade Organization (WTO) negotiations, if
a country agrees to reduce trade barriers (tariffs or
quotas), it usually refers to this as a concession to
other countries. Do you think that this terminology
is appropriate?
14. Producers in import-competing industries often
make the following argument: “Other countries have
an advantage in production of certain goods purely
because workers abroad are paid lower wages. In
fact, American workers are much more productive
than foreign workers. So import-competing industries need to be protected.” Is this a valid argument?
Explain your answer.
WORK IT OUT
For interactive, step-by-step help in solving the following problem,
visit
by using the URL on the back cover of this book.
15. Assume Saudi Arabia and the United States face the
production possibilities for oil and cars shown in the
accompanying table.
Saudi Arabia
United States
Quantity of oil
Quantity of oil
(millions
Quantity of
(millions of
Quantity of
of barrels)
cars (millions)
barrels)
cars (millions)
0
4
0
10.0
200
3
100
7.5
400
2
200
5.0
600
1
300
2.5
800
0
400
0
a. What is the opportunity cost of producing a car
in Saudi Arabia? In the United States? What is
the opportunity cost of producing a barrel of oil
in Saudi Arabia? In the United States?
b. Which country has the comparative advantage in
producing oil? In producing cars?
c. Suppose that in autarky, Saudi Arabia produces
200 million barrels of oil and 3 million cars; similarly, that the United States produces 300 million
barrels of oil and 2.5 million cars. Without trade,
can Saudi Arabia produce more oil and more cars?
Without trade, can the United States produce more
oil and more cars?
Suppose now that each country specializes in the
good in which it has the comparative advantage,
and the two countries trade. Also assume that for
each country the value of imports must equal the
value of exports.
d. What is the total quantity of oil produced? What
is the total quantity of cars produced?
e. Is it possible for Saudi Arabia to consume 400
million barrels of oil and 5 million cars and for
the United States to consume 400 million barrels
of oil and 5 million cars?
f. Suppose that, in fact, Saudi Arabia consumes
300 million barrels of oil and 4 million cars and
the United States consumes 500 million barrels
of oil and 6 million cars. How many barrels of oil
does the United States import? How many cars
does the United States export? Suppose a car costs
$10,000 on the world market. How much, then,
does a barrel of oil cost on the world market?
CHAPTER
Consumer and
Producer Surplus
The concepts of consumer surplus and producer surplus are extremely useful for
analyzing a wide variety of economic issues. They let us calculate how much
benefit producers and consumers receive from the existence of a market. They
also allow us to calculate how the welfare of consumers and producers is affected
by changes in market prices. Such calculations play a crucial role in evaluating
many economic policies, and they are especially useful in understanding the
effects of trade.
All we need in order to calculate consumer surplus are the demand and supply curves for a good. That is, the supply and demand model isn’t just a model
of how a competitive market works—it’s also a model of how much consumers
and producers gain from participating in that market. Our starting point is the
market in used textbooks, a big business in terms of dollars and cents—several
billion dollars each year. More importantly for us, it is useful for developing the
concepts of consumer and producer surplus.
5
APPENDIX
A consumer’s willingness to pay for
a good is the maximum price at which
he or she would buy that good.
Consumer Surplus and the Demand Curve
Let’s look at the market for used textbooks, starting with the buyers. The key
point, as we’ll see in a minute, is that the demand curve is derived from their
tastes or preferences—and that those same preferences also determine how much
they gain from the opportunity to buy used books.
Willingness to Pay and the Demand Curve
A used book is not as good as a new book—it will be battered and coffee­-­stained,
may include someone else’s highlighting, and may not be completely up to date.
How much this bothers you depends on your preferences. Some potential buyers
would prefer to buy the used book even if it is only slightly cheaper than a new
one; others would buy the used book only if it is considerably cheaper.
Let’s define a potential buyer’s willingness to pay as the maximum price at
which he or she would buy a good, in this case a used textbook. An individual
won’t buy the book if it costs more than this amount but is eager to do so if it
costs less. If the price is just equal to an individual’s willingness to pay, he or she
is indifferent between buying and not buying.
Table 5A-1 shows five potential buyers of a used book that costs $100 new,
listed in order of their willingness to pay. At one extreme is Aleisha, who will buy
a second-­hand book even if the price is
TABLE 5A-1
Consumer Surplus If Price of a Used Textbook = $30
as high as $59. Brad is less willing to
Potential
Willingness
Price
Individual consumer surplus
have a used book and will buy one only
buyer
to pay
paid
 Willingness to pay  Price paid
if the price is $45 or less. Claudia is willAleisha
$59
$30
$29
ing to pay only $35; Darren, only $25.
Brad
45
30
15
And Edwina, who really doesn’t like the
idea of a used book, will buy one only if
Claudia
35
30
5
it costs no more than $10.
Darren
25
—
—
How many of these five students will
Edwina
10
—
—
actually buy a used book? It depends on
All
buyers
Total
consumer
surplus  $49
the price. If the price of a used book is $55,
163
164
PA R T 2
S U P P LY A N D D E M A N D
Individual consumer surplus is
the net gain to an individual buyer
from the purchase of a good. It is
equal to the difference between the
buyer’s willingness to pay and the
price paid.
only Aleisha buys one; if the price is $40, Aleisha and Brad both buy used books, and
so on. So the information in the table on willingness to pay also defines the demand
schedule for used textbooks.
Total consumer surplus is the
sum of the individual consumer
surpluses of all the buyers of a
good in a market.
Suppose that the campus bookstore makes used textbooks available at a price of
$30. In that case Aleisha, Brad, and Claudia will buy books. Do they gain from
their purchases, and if so, how much?
The answer, also shown in Table 5A-1, is that each student who purchases a book
does achieve a net gain but that the amount of the gain differs among students.
Aleisha would have been willing to pay $59, so her net gain is $59 − $30 = $29. Brad
would have been willing to pay $45, so his net gain is $45 − $30 = $15. Claudia would
have been willing to pay $35, so her net gain is $35 − $30 = $5. Darren and Edwina, however, won’t be willing to buy a used book at a price of $30, so they neither gain nor lose.
The net gain that a buyer achieves from the purchase of a good is called that
buyer’s individual consumer surplus. What we learn from this example is that
whenever a buyer pays a price less than his or her willingness to pay, the buyer
achieves some individual consumer surplus.
The sum of the individual consumer surpluses achieved by all the buyers of a
good is known as the total consumer surplus achieved in the market. In Table
5A-1, the total consumer surplus is the sum of the individual consumer surpluses
achieved by Aleisha, Brad, and Claudia: $29 + $15 + $5 = $49.
Economists often use the term consumer surplus to refer to both individual
and total consumer surplus. We will follow this practice; it will always be clear
in context whether we are referring to the consumer surplus achieved by an individual or by all buyers.
Total consumer surplus can be represented graphically. As we saw in Chapter 3,
we can use the demand schedule to derive the market demand curve shown in Figure
5A-1. Because we are considering only a small number of consumers, this curve
doesn’t look like the smooth demand curves of Chapter 3, where markets contained
hundreds or thousands of consumers. Instead, this demand curve is stepped, with
alternating horizontal and vertical segments.
Each horizontal segment—each step—corresponds to one potential buyer’s willingness to pay. Each step in that demand curve is one book wide and represents one
consumer. For example, the height of Aleisha’s step is $59, her willingness to pay.
This step forms the top of a rectangle, with $30—the price she actually pays for a
book—forming the bottom. The area of Aleisha’s rectangle, ($59 − $30) × 1 = $29, is
The term consumer surplus is
often used to refer to both individual
and total consumer surplus.
FIGURE 5A-1
Willingness to Pay and Consumer Surplus
Consumer Surplus in the Used­-­Textbook Market
At a price of $30, Aleisha, Brad, and Claudia each buy a
book but Darren and Edwina do not. Aleisha, Brad, and
Claudia get individual consumer surpluses equal to the
difference between their willingness to pay and the price,
illustrated by the areas of the shaded rectangles. Both
Darren and Edwina have a willingness to pay less than
$30, so they are unwilling to buy a book in this market; they
receive zero consumer surplus. The total consumer surplus
is given by the entire shaded area—the sum of the individual
consumer surpluses of Aleisha, Brad, and Claudia—equal to
$29 + $15 + $5 = $49.
Price of
book
Aleisha’s consumer surplus:
$59 – $30 = $29
Aleisha
$59
Brad’s consumer surplus:
$45 – $30 = $15
Brad
45
Claudia
35
30
25
Claudia’s consumer surplus:
$35 – $30 = $5
Darren
Price = $30
Edwina
10
D
0
1
2
3
4
5
Quantity of books
CHAPTER 5
A P P E N D I X : CONSUMER AND PRODUCER SURPLUS
165
her consumer surplus from purchasing one book at $30. So the individual consumer
surplus Aleisha gains is the area of the dark blue rectangle shown in Figure 5A-1.
In addition to Aleisha, Brad and Claudia will also each buy a book when the
price is $30. Like Aleisha, they benefit from their purchases, though not as much,
because they each have a lower willingness to pay. Figure 5A-1 also shows the
consumer surplus gained by Brad and Claudia; again, this can be measured by
the areas of the appropriate rectangles. Darren and Edwina, because they do not
buy books at a price of $30, receive no consumer surplus.
The total consumer surplus achieved in this market is just the sum of the individual consumer surpluses received by Aleisha, Brad, and Claudia. So total consumer surplus is equal to the combined area of the three rectangles—the entire
shaded area in Figure 5A-1. Another way to say this is that total consumer surplus
is equal to the area below the demand curve but above the price.
This illustrates the following general principle: the total
consumer surplus generated by purchases of a good at a
FIGURE 5A-2 Consumer Surplus
given price is equal to the area below the demand curve but
above that price. The same principle applies regardless of
Price of
iPhone
the number of consumers.
For large markets, such as the market for smart
phones that was used in the chapter, this graphical representation of consumer surplus becomes extremely
helpful. Consider, for example, the sales of iPhones to
Consumer surplus
millions of potential buyers. Each potential buyer has
Price = $500
$500
a maximum price that he or she is willing to pay. With
D
so many potential buyers, the demand curve will be
0
1 million
smooth, like the one shown in Figure 5A-2.
Quantity of iPhones
Suppose that at a price of $500, a total of 1 million
iPhones are purchased. How much do consumers gain
The demand curve for iPhones is smooth because there are
from being able to buy those 1 million iPhones? We
many potential buyers. At a price of $500, 1 million iPhones
could answer that question by calculating the consumer
are demanded. The consumer surplus at this price is equal to
surplus of each individual buyer and then adding these
the shaded area: the area below the demand curve but above
numbers up to arrive at a total. But it is much easier
the price. This is the total net gain to consumers generated
just to look at Figure 5A-2 and use the fact that the total
from buying and consuming iPhones when the price is $500.
consumer surplus is equal to the shaded area. As in our
original example, consumer surplus is equal to the area
below the demand curve but above the price. (You can refresh your memory on how
to calculate the area of a right triangle by reviewing the appendix to Chapter 2.)
Producer Surplus and the Supply Curve
Just as some buyers of a good would have been willing to pay more for their purchase
than the price they actually pay, some sellers of a good would have been willing to
sell it for less than the price they actually receive. So just as there are consumers who
receive consumer surplus from buying in a market, there are producers who receive
producer surplus from selling in a market.
Producer Surplus If Price of a
TABLE 5A-2
Used Textbook = $30
Cost and Producer Surplus
Consider a group of students who are potential sellers of used
textbooks. Because they have different preferences, the various
potential sellers differ in the price at which they are willing to
sell their books. Table 5A-2 shows the prices at which several
different students would be willing to sell. Andrew is willing to
sell the book as long as he can get at least $5; Betty won’t sell
unless she can get at least $15; Carlos, unless he can get $25;
Donna, unless she can get $35; Engelbert, unless he can get $45.
Potential
seller
Cost
Price
received
Individual producer surplus
 Price received  Cost
Andrew
$5
$30
$25
Betty
15
30
15
Carlos
25
30
5
Donna
35
—
—
Engelbert
45
—
—
All sellers
Total producer surplus  $45
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PA R T 2
S U P P LY A N D D E M A N D
A seller’s cost is the lowest price
at which he or she is willing to sell
a good.
Individual producer surplus is
the net gain to an individual seller
from selling a good. It is equal to
the difference between the price
received and the seller’s cost.
Total producer surplus in a market
is the sum of the individual producer
surpluses of all the sellers of a good
in a market.
Economists use the term producer
surplus to refer to either total or
individual producer surplus.
FIGURE 5A-3
The lowest price at which a potential seller is willing to sell has a special name
in economics: it is called the seller’s cost. So Andrew’s cost is $5, Betty’s is $15,
and so on.
Using the term cost, which people normally associate with the monetary cost of
producing a good, may sound a little strange when applied to sellers of used textbooks. The students don’t have to manufacture the books, so it doesn’t cost the student who sells a used textbook anything to make that book available for sale, does it?
Yes, it does. A student who sells a book won’t have it later, as part of his or
her personal collection. So there is an opportunity cost to selling a textbook, even
if the owner has completed the course for which it was required. And remember
that one of the basic principles of economics is that the true measure of the cost
of doing something is always its opportunity cost. That is, the real cost of something is what you must give up to get it.
So it is good economics to talk of the minimum price at which someone will
sell a good as the “cost” of selling that good, even if he or she doesn’t spend any
money to make the good available for sale. Of course, in most real­-­world markets
the sellers are also those who produce the good and therefore do spend money to
make the good available for sale. In this case the cost of making the good available
for sale includes monetary costs, but it may also include other opportunity costs.
Getting back to the example, suppose that Andrew sells his book for $30.
Clearly he has gained from the transaction: he would have been willing to sell
for only $5, so he has gained $25. This net gain, the difference between the price
he actually gets and his cost—the minimum price at which he would have been
willing to sell—is known as his individual producer surplus.
As in the case of consumer surplus, we can add the individual producer surpluses of sellers to calculate the total producer surplus, the total net gain to
all sellers in the market. Economists use the term producer surplus to refer to
either individual or total producer surplus. Table 5A-2 shows the net gain to each
of the students who would sell a used book at a price of $30: $25 for Andrew, $15
for Betty, and $5 for Carlos. The total producer surplus is $25 + $15 + $5 = $45.
As with consumer surplus, the producer surplus gained by those who sell
books can be represented graphically. Just as we derived the demand curve from
the willingness to pay of different consumers, we derive the supply curve from the
cost of different producers. The step-shaped curve in Figure 5A-3 shows the supply curve implied by the cost shown in Table 5A-2. Each step in the supply curve
is one book wide and represents one seller. The height of Andrew’s step is $5, his
cost. This forms the bottom of a rectangle, with $30, the price he actually receives
for his book, forming the top. The area of this rectangle, ($30 − $5) × 1 = $25, is his
Producer Surplus in the Used­-­Textbook Market
At a price of $30, Andrew, Betty, and Carlos each sell a
book but Donna and Engelbert do not. Andrew, Betty, and
Carlos get individual producer surpluses equal to the difference
between the price and their cost, illustrated here by the shaded
rectangles. Donna and Engelbert each have a cost that is
greater than the price of $30, so they are unwilling to sell a book
and so receive zero producer surplus. The total producer surplus
is given by the entire shaded area, the sum of the individual
producer surpluses of Andrew, Betty, and Carlos, equal to
$25 + $15 + $5 = $45.
Price of
book
S
Engelbert
$45
Donna
35
30
25
Price = $30
15
Betty
Andrew’s
producer
surplus
Andrew
5
0
Carlos’s
producer
surplus
Carlos
1
2
3
4
5
Betty’s
producer
surplus
Quantity of books
CHAPTER 5
A P P E N D I X : CONSUMER AND PRODUCER SURPLUS
167
producer surplus. So the producer surplus Andrew gains from selling his book is
the area of the dark red rectangle shown in the figure.
Let’s assume that the campus bookstore is willing to buy all the used copies
of this book that students are willing to sell at a price of $30. Then, in addition to
Andrew, Betty and Carlos will also sell their books. They will also benefit from
their sales, though not as much as Andrew, because
they have higher costs. Andrew, as we have seen, gains
FIGURE 5A-4 Producer Surplus
$25. Betty gains a smaller amount: since her cost is
$15, she gains only $15. Carlos gains even less, only $5.
Price of
Again, as with consumer surplus, we have a general
wheat
S
rule for determining the total producer surplus from
(per bushel)
sales of a good: The total producer surplus from sales of
a good at a given price is the area above the supply curve
but below that price.
Price = $5
$5
Producer
This rule applies both to examples like the one
surplus
shown in Figure 5A-3, where there are a small number
of producers and a step­-­shaped supply curve, and to
more realistic examples, where there are many producers and the supply curve is smooth.
0
1 million
Consider, for example, the supply of wheat. Figure
Quantity of wheat (bushels)
5A-4 shows how producer surplus depends on the price
per bushel. Suppose that, as shown in the figure, the
Here is the supply curve for wheat. At a price of $5 per bushel,
price is $5 per bushel and farmers supply 1 million
farmers supply 1 million bushels. The producer surplus at this
bushels. What is the benefit to the farmers from selling
price is equal to the shaded area: the area above the supply curve
their wheat at a price of $5? Their producer surplus is
but below the price. This is the total gain to producers—farmers in
this case—from supplying their product when the price is $5.
equal to the shaded area in the figure—the area above
the supply curve but below the price of $5 per bushel.
The Gains from Trade
Let’s return to the market for used textbooks, but now consider a much bigger
market—say, one at a large state university. There are many potential buyers and sellers, so the market is competitive. Let’s line up incoming students who are potential
buyers of a book in order of their willingness to pay, so that the entering student with
the highest willingness to pay is potential buyer number 1, the student with the next
highest willingness to pay is number 2, and so on. Then we can use their willingness
to pay to derive a demand curve like the one in Figure 5A-5. Similarly, we can line up
outgoing students, who are potential sellers of the book, in order of their cost, starting
FIGURE 5A-5
Total Surplus
In the market for used textbooks, the equilibrium price
is $30 and the equilibrium quantity is 1,000 books.
Consumer surplus is given by the blue area, the area
below the demand curve but above the price. Producer
surplus is given by the red area, the area above the supply
curve but below the price. The sum of the blue and the red
areas is total surplus, the total benefit to society from the
production and consumption of the good.
Price
of book
Equilibrium
price
$30
S
Consumer
surplus
E
Producer
surplus
D
0
1,000
Quantity of books
Equilibrium quantity
168
PA R T 2
S U P P LY A N D D E M A N D
with the student with the lowest cost, then the student with the next lowest cost, and so
on, to derive a supply curve like the one shown in the same figure.
As we have drawn the curves, the market reaches equilibrium at a price of
$30 per book, and 1,000 books are bought and sold at that price. The two shaded
triangles show the consumer surplus (blue) and the producer surplus (red) generated by this market. The sum of consumer and producer surplus is known as the
total surplus generated in a market.
The striking thing about this picture is that both consumers and producers
gain—that is, both consumers and producers are better off because there is a
market in this good. But this should come as no surprise—it illustrates a core
principle of economics that you learned about in Chapters 1, 2, and 5: There are
gains from trade. These gains from trade are the reason everyone is better off
participating in a market economy than they would be if each individual tried to
be self­-­sufficient.
The total surplus generated in
a market is the total net gain to
consumers and producers from
trading in the market. It is the sum
of the consumer and the producer
surplus.
PROBLEMS
1. Determine the amount of consumer surplus generated
a. Suppose that the price of each ride is $5. At that price,
in each of the following situations.
a. Leon goes to the clothing store to buy a new T-shirt,
for which he is willing to pay up to $10. He picks out
one he likes with a price tag of exactly $10. When he
is paying for it, he learns that the T-shirt has been
discounted by 50%.
b. Alberto goes to the music store hoping to find a used
copy of Nirvana’s Nevermind for up to $10. The store
has one copy selling for $10, which he purchases.
c. After soccer practice, Stacey is willing to pay $2 for
a bottle of mineral water. The 7-Eleven sells mineral
water for $2.25 per bottle, so she declines to purchase it.
how much consumer surplus does an individual consumer get? (Recall that the area of a right triangle is
½ × the height of the triangle × the base of the triangle.)
b. Suppose that Fun World considers charging an
admission fee, even though it maintains the price of
each ride at $5. What is the maximum admission fee
it could charge? (Assume that all potential customers have enough money to pay the fee.)
c. Suppose that Fun World lowered the price of each
ride to zero. How much consumer surplus does an
individual consumer get? What is the maximum
admission fee Fun World could charge?
2. Determine the amount of producer surplus generated in
4. The accompanying diagram illustrates a taxi driver’s
each of the following situations.
a. Gordon lists his old Lionel electric trains on eBay.
He sets a minimum acceptable price, known as his
reserve price, of $75. After five days of bidding, the
final high bid is exactly $75. He accepts the bid.
b. So-Hee advertises her car for sale in the used­-­car section of the student newspaper for $2,000, but she is
willing to sell the car for any price higher than $1,500.
The best offer she gets is $1,200, which she declines.
c. Sanjay likes his job so much that he would be willing
to do it for free. However, his annual salary is $80,000.
individual supply curve (assume that each taxi ride is
the same distance).
3. You are the manager of Fun World, a small amuse-
ment park. The accompanying diagram shows the
demand curve of a typical customer at Fun World.
Price
of ride
$10
5
D
0
10
20
Quantity of rides (per day)
Price of
taxi ride
S
$8
4
0
40
80
Quantity of taxi rides
a. Suppose the city sets the price of taxi rides at $4 per
ride, and at $4 the taxi driver is able to sell as many taxi
rides as he desires. What is this taxi driver’s producer
surplus? (Recall that the area of a right triangle is ½ ×
the height of the triangle × the base of the triangle.)
b. Suppose that the city keeps the price of a taxi ride
set at $4, but it decides to charge taxi drivers a
“licensing fee.” What is the maximum licensing fee
the city could extract from this taxi driver?
c. Suppose that the city allowed the price of taxi rides
to increase to $8 per ride. Again assume that, at this
price, the taxi driver sells as many rides as he is willing to offer. How much producer surplus does an
individual taxi driver now get? What is the maximum
licensing fee the city could charge this taxi driver?
CHAPTER
Macroeconomics:
The Big Picture
RLD VIE
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6
THE PAIN IN SPAIN
s
What You Will Learn
in This Chapter
What makes macroeconomics
•different
from microeconomics
a business cycle is
•andWhat
why policy makers seek to
diminish the severity of business
cycles
How long-run economic
•growth
determines a country’s
standard of living
•
The meaning of inflation and
deflation and why price stability
is preferred
and how economies interact
through trade deficits and trade
surpluses
Luca Piergiovanni/Demotix/Corbis
The importance of open•economy
macroeconomics
In 2011 Spanish students protest government cuts and the lack of jobs, holding aloft a
banner that proclaimed, “The Youth say ‘Enough’!”
I
N 2012 JAVIER DIAZ, A 25-YEARold Spanish college graduate, found
himself where he never expected to
be: unemployed and living at home. He
went to college with the intention of
becoming a teacher, but by the time he
graduated, no one would offer him a job.
And we mean any kind of job. Diaz was
willing to work at McDonald’s, but even
that wasn’t an option.
Was this lack of job prospects a reflection on Mr. Diaz’s qualifications? Probably
not. No matter who you were, finding a
job in Spain in the year 2012 was tough
indeed. Of Spaniards under the age of 25
seeking work, 57%—that’s right, 57%—
were unemployed. Having a college degree
didn’t help much: the unemployment rate
among recent college graduates was 39%.
Yet it wasn’t always like that. Five
years earlier Mr. Diaz probably would
have found it fairly easy to get a job that
made use of his education. In 2007–2008,
however, much of the world economy,
the United States included, plunged into
a severe slump. The United States and
some other countries began recovering
from the slump in 2009, although the
recovery was slow and painful. But as
of 2012 Spain and a number of other
European countries hadn’t recovered at
all—in fact, unemployment kept rising.
As bad as things were for the global
economy after 2007, they could have
been much worse. In fact, they were
much worse during an epic global slump
that began in 1929 and persisted until
the beginning of World War II. It was a
time of severe economic troubles known
as the Great Depression. To emphasize
that the troubles were the worst since
the Great Depression, economists refer to
the downturn that began in 2007 as the
Great Recession.
Why wasn’t the slump after 2007
as bad as the slump after 1929? There
were many reasons, but one stands out:
economists learned something about
what to do from the earlier catastrophe. When the Great Depression struck,
political leaders and their economic
advisers literally had no idea what to do.
Fortunately, during the Great Recession
they did know what needed to be done,
although not all of the good advice on
offer was taken.
At the time of the Great Depression,
microeconomics, which is concerned
with the consumption and production
decisions of individual consumers and
producers and with the allocation of
scarce resources among industries,
was already a well-developed branch of
economics. But macroeconomics, which
focuses on the behavior of the economy
as a whole, was still in its infancy.
169
170
PA R T 3
INTRODUCTION TO MACROECONOMICS
What happened to much of the world
during the Great Depression and during
the Great Recession—and has happened
in many other times and places, although
rarely with the same severity—was a
blow to the economy as a whole. During
normal times, at any given moment there
are always some industries laying off
workers. For example, the number of
independent record stores in America fell
almost 30% between 2003 and 2007, as
consumers turned to online purchases.
But workers who lost their jobs at record
stores had a good chance of finding new
jobs elsewhere, because other industries
were expanding even as record stores
shut their doors. However, in Europe and
America during the Great Recession,
there were no expanding industries:
everything was headed downward.
Macroeconomics came into its own as
a branch of economics during the Great
Depression. Economists realized that they
needed to understand the nature of the
catastrophe that had overtaken the United
States and much of the rest of the world in
order to extricate themselves, as well as
to learn how to avoid such catastrophes
in the future. To this day, the effort to
understand economic slumps and find
ways to prevent them is at the core of
macroeconomics. Over time, however,
macroeconomics has broadened its reach
to encompass a number of other subjects,
such as long-run economic growth, inflation, and open-economy macroeconomics.
This chapter offers an overview of
macroeconomics. We start with a general description of the difference between
macroeconomics and microeconomics,
then briefly describe some of the field’s
major concerns.
The Nature of Macroeconomics
What makes macroeconomics different from microeconomics? The distinguishing feature of macroeconomics is that it focuses on the behavior of the economy
as a whole.
Macroeconomic Questions
Table 6-1 lists some typical questions that involve economics. A microeconomic
version of the question appears on the left paired with a similar macroeconomic question on the right. By
TABLE 6-1
Microeconomic versus Macroeconomic Questions
comparing the questions, you can
begin to get a sense of the differMicroeconomic Questions
Macroeconomic Questions
ence between microeconomics and
Should I go to business school or take a
How many people are employed in the
macroeconomics.
job right now?
economy as a whole this year?
As these questions illustrate,
What determines the salary offered by
What determines the overall salary levels
microeconomics focuses on how
Citibank to Cherie Camajo, a new MBA?
paid to workers in a given year?
decisions are made by individuals
What determines the cost to a university or What determines the overall level of prices
and firms and the consequences of
college of offering a new course?
in the economy as a whole?
those decisions. For example, we
What government policies should be
What government policies should be
use microeconomics to determine
adopted to promote employment and
adopted to make it easier for low-income
how much it would cost a universigrowth in the economy as a whole?
students to attend college?
ty or college to offer a new course,
What determines whether Citibank opens a What determines the overall trade in goods,
which includes the instructor’s salnew office in Shanghai?
services, and financial assets between the
United States and the rest of the world?
ary, the cost of class materials, and
so on. The school can then decide
whether or not to offer the course by weighing the costs and benefits.
Macroeconomics, in contrast, examines the overall behavior of the economy—
how the actions of all the individuals and firms in the economy interact to produce a particular economy-wide level of economic performance. For example,
macroeconomics is concerned with the general level of prices in the economy and
how high or how low it is relative to the general level of prices last year, rather
than with the price of one particular good or service.
You might imagine that macroeconomic questions can be answered simply
by adding up microeconomic answers. For example, the model of supply and
demand we introduced in Chapter 3 tells us how the equilibrium price of an
individual good or service is determined in a competitive market. So you might
think that applying supply and demand analysis to every good and service in the
CHAPTER 6
MACROECONOMICS: THE BIG PICTURE
171
economy, then summing the results, is the way to understand the overall level of
prices in the economy as a whole.
But that turns out not to be right: although basic concepts such as supply
and demand are as essential to macroeconomics as they are to microeconomics,
answering macroeconomic questions requires an additional set of tools and an
expanded frame of reference.
If you occasionally drive on a highway, you probably know what a rubber-necking
traffic jam is and why it is so annoying. Someone pulls over to the side of the road
for something minor, such as changing a flat tire, and, pretty soon, a long traffic
jam occurs as drivers slow down to take a look.
What makes it so annoying is that the length of the traffic jam is greatly out of
proportion to the minor event that precipitated it. Because some drivers hit their
brakes in order to rubber-neck, the drivers behind them must also hit their brakes,
those behind them must do the same, and so on. The accumulation of all the
individual hitting of brakes eventually leads to a long, wasteful traffic jam as each
driver slows down a little bit more than the driver in front of him or her. In other
words, each person’s response leads to an amplified response by the next person.
Understanding a rubber-necking traffic jam gives us some insight into one
very important way in which macroeconomics is different from microeconomics:
many thousands or millions of individual actions compound upon one another to
produce an outcome that isn’t simply the sum of those individual actions.
Consider, for example, what macroeconomists call the paradox of thrift: when
families and businesses are worried about the possibility of economic hard times,
they prepare by cutting their spending. This reduction in spending depresses the
economy as consumers spend less and businesses react by laying off workers. As
a result, families and businesses may end up worse off than if they hadn’t tried to
act responsibly by cutting their spending.
This is a paradox because seemingly virtuous behavior—preparing for hard
times by saving more—ends up harming everyone. And there is a flip-side to this
story: when families and businesses are feeling optimistic about the future, they
spend more today. This stimulates the economy, leading businesses to hire more workers, which further expands the economy. Seemingly profligate behavior leads to good times for all.
Or consider what happens when something causes the
quantity of cash circulating through the economy to rise. An
individual with more cash on hand is richer. But if everyone
has more cash, the long-run effect is simply to push the
overall level of prices higher, taking the purchasing power of
the total amount of cash in circulation right back to where
it was before.
A key insight of macroeconomics, then, is that the combined effect of individual decisions can have results that are
very different from what any one individual intended, results
that are sometimes perverse. The behavior of the macroeconomy is, indeed, greater than the sum of individual actions
The behavior of the macroeconomy is greater than the sum of
individual actions and market outcomes.
and market outcomes.
Macroeconomics: Theory and Policy
To a much greater extent than microeconomists, macroeconomists are concerned
with questions about policy, about what the government can do to make macroeconomic performance better. This policy focus was strongly shaped by history,
in particular by the Great Depression of the 1930s.
SFC/Shutterstock
Macroeconomics: The Whole Is Greater
Than the Sum of Its Parts
PA R T 3
INTRODUCTION TO MACROECONOMICS
In a self-regulating economy,
problems such as unemployment
are resolved without government
intervention, through the working of
the invisible hand.
According to Keynesian
economics, economic slumps are
caused by inadequate spending, and
they can be mitigated by government
intervention.
Monetary policy uses changes in
the quantity of money to alter interest
rates and affect overall spending.
Fiscal policy uses changes in
government spending and taxes to
affect overall spending.
Before the 1930s, economists tended to regard the economy as self-regulating:
they believed that problems such as unemployment would be corrected through
the working of the invisible hand and that government attempts to improve the
economy’s performance would be ineffective at best—and would probably make
things worse.
The Great Depression changed all that. The sheer scale of the catastrophe,
which left a quarter of the U.S. workforce without jobs and threatened the political stability of many countries—the Depression is widely believed to have been
a major factor in the Nazi takeover of Germany—created a demand for action.
It also led to a major effort on the part of economists to understand economic
slumps and find ways to prevent them.
In 1936 the British economist John Maynard Keynes (pronounced “canes”)
published The General Theory of Employment, Interest, and Money, a book that
transformed macroeconomics. According to Keynesian economics, a depressed
economy is the result of inadequate spending. In addition, Keynes argued that
government intervention can help a depressed economy through monetary policy
and fiscal policy. Monetary policy uses changes in the quantity of money to alter
interest rates, which in turn affect the level of overall spending. Fiscal policy
uses changes in taxes and government spending to affect overall spending.
In general, Keynes established the idea that managing the economy is a government responsibility. Keynesian ideas continue to have a strong influence on
both economic theory and public policy: in 2008 and 2009, Congress, the White
House, and the Federal Reserve (a quasi-governmental agency that manages
U.S. monetary policy) took steps to fend off an economic slump that were clearly
Keynesian in spirit, as described in the following Economics in Action.
in Action
RLD VIE
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ECONOMICS
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172
Fending Off Depression
I
n 2008 the world economy experienced a severe financial crisis that was all too
reminiscent of the early days of the Great Depression. Major banks teetered on
the edge of collapse; world trade slumped. In the spring of 2009, the economic
historians Barry Eichengreen and Kevin O’Rourke, reviewing the available data,
pointed out that “globally we are tracking or even doing worse than the Great
Depression.”
Measures of Economic Activity and World Industrial
But the worst did not, in the
Production During the Great Depression and the
end, come to pass. Figure 6-1
FIGURE 6-1
Great Recession
shows one of Eichengreen and
O’Rourke’s measures of ecoWorld industrial output
nomic
activity, world industrial
(index, June 1929 = 100,
Industrial output since
production, during the Great
April 2008 = 100)
peak in April 2008
Depression (the top line) and
110
during the Great Recession (the
100
bottom line). During the first
90
year the two crises were indeed
80
comparable. But fortunately, one
70
year into the Great Recession,
60
Industrial output since
world production leveled off and
peak in June 1929
50
turned around. In contrast, three
years into the Great Depression
3
7 11 15 19 23 27 31 35 39 43 47 51
world production continued to
Months since peak in output
fall. Why the difference?
Source: Barry Eichengreen and Kevin O’Rourke (2009), “A Tale of Two Depressions.” © VoxEU.org; CPB
At least part of the answer
Netherlands Bureau for Economic Policy Analysis World Trade Monitor.
is that policy makers responded
CHAPTER 6
MACROECONOMICS: THE BIG PICTURE
very differently. During the Great Depression, it was widely argued that the slump
should simply be allowed to run its course. Any attempt to mitigate the ongoing
catastrophe, declared Joseph Schumpeter—the Austrian-born Harvard economist now famed for his work on innovation—would “leave the work of depression
undone.” In the early 1930s, some countries’ monetary authorities actually raised
interest rates in the face of the slump, while governments cut spending and raised
taxes—actions that, as we’ll see in later chapters, deepened the recession.
In the aftermath of the 2008 crisis, by contrast, interest rates were slashed, and
a number of countries, the United States included, used temporary increases in
spending and reductions in taxes in an attempt to sustain spending. Governments
also moved to shore up their banks with loans, aid, and guarantees.
Many of these measures were controversial, to say the least. But most economists
believe that by responding actively to the Great Recession—and doing so using the
knowledge gained from the study of macroeconomics—governments helped avoid a
global economic catastrophe.
173
Quick Review
• Microeconomics focuses on
Check Your Understanding
6-1
1. Which of the following questions involve microeconomics, and which involve macroeconomics? In each case, explain your answer.
a. Why did consumers switch to smaller cars in 2008?
b. Why did overall consumer spending slow down in 2008?
c. Why did the standard of living rise more rapidly in the first generation after
World War II than in the second?
d. Why have starting salaries for students with geology degrees risen sharply of
late?
e. What determines the choice between rail and road transportation?
f. Why did salmon get much cheaper between 1980 and 2000?
g. Why did inflation fall in the 1990s?
2.In 2008, problems in the financial sector led to a drying up of credit around the
country: home-buyers were unable to get mortgages, students were unable to get
student loans, car-buyers were unable to get car loans, and so on.
a. Explain how the drying up of credit can lead to compounding effects throughout the economy and result in an economic slump.
b If you believe the economy is self-regulating, what would you advocate that
policy makers do?
c. If you believe in Keynesian economics, what would you advocate that policy
makers do?
Solutions appear at back of book.
The Business Cycle
The Great Depression was by far the worst economic crisis in U.S. history. But
although the economy managed to avoid catastrophe for the rest of the twentieth
century, it has experienced many ups and downs.
It’s true that the ups have consistently been bigger than the downs: a chart of
any of the major numbers used to track the U.S. economy shows a strong upward
trend over time. For example, panel (a) of Figure 6-2 shows total U.S. privatesector employment (the total number of jobs offered by private businesses) measured along the left vertical axis, with the data from 1985 to 2014 given by the
purple line. The graph also shows the index of industrial production (a measure
of the total output of U.S. factories) measured along the right vertical axis, with
the data from 1985 to 2014 given by the red line. Both private-sector employment
and industrial production were much higher at the end of this period than at the
beginning, and in most years both measures rose.
decision making by individuals and
firms and the consequences of the
decisions made. Macroeconomics
focuses on the overall behavior of
the economy.
• The combined effect of
individual actions can have
unintended consequences and lead
to worse or better macroeconomic
outcomes for everyone.
• Before the 1930s, economists
tended to regard the economy as
self-regulating. After the Great
Depression, Keynesian economics
provided the rationale for
government intervention through
monetary policy and fiscal policy
to help a depressed economy.
U.S. Growth, Interrupted, 1985–2014
(a) Private–Sector Employment and Industrial Production Index
–3
0
Private-sector
employment
–6
–9
Year
Panel (a) shows two important economic numbers, the industrial production index and total private-sector employment. Both
numbers grew substantially from 1985 to 2014, but they didn’t
grow steadily. Instead, both suffered from three downturns
associated with recessions, which are indicated by the shaded
areas in the figure. Panel (b) emphasizes those downturns by
Recessions, or contractions, are
periods of economic downturn when
output and employment are falling.
Expansions, or recoveries, are
periods of economic upturn when
output and employment are rising.
The business cycle is the short-run
alternation between recessions and
expansions.
The point at which the economy
turns from expansion to recession is
a business-cycle peak.
The point at which the economy
turns from recession to expansion is
a business-cycle trough.
20
14
–12
10
14
80
70
60
50
20
10
20
05
20
00
20
95
19
90
19
19
85
80,000
3
20
90,000
100
90
05
100,000
6
20
110,000
9%
00
120,000
Industrial
production index
20
130,000
Percent
change
95
140,000
Industrial
production
index (2007
= 100)
120
110
Private-sector
employment
85
Industrial
production
index
19
Private-sector
employment
(thousands)
(b) Percent Change from Year Earlier
19
FIGURE 6-2
INTRODUCTION TO MACROECONOMICS
90
PA R T 3
19
174
Year
showing the annual rate of change of industrial production and
employment, that is, the percentage increase over the past year.
The simultaneous downturns in both numbers during the three
recessions are clear.
Source: Federal Reserve Bank of St. Louis.
But they didn’t rise steadily. As you can see from the figure, there were three
periods—in the early 1990s, in the early 2000s, and again beginning in late
2007—when both employment and industrial output stumbled. Panel (b) emphasizes these stumbles by showing the rate of change of employment and industrial
production over the previous year. For example, the percent change in employment for December 2007 was 0.7, because employment in December 2007 was
0.7% higher than it had been in December 2006. The three big downturns stand
out clearly. What’s more, a detailed look at the data makes it clear that in each
period the stumble wasn’t confined to only a few industries: in each downturn,
just about every sector of the U.S. economy cut back on production and on the
number of people employed.
The economy’s forward march, in other words, isn’t smooth. And the uneven
pace of the economy’s progress, its ups and downs, is one of the main preoccupations of macroeconomics.
Charting the Business Cycle
Figure 6-3 shows a stylized representation of the way the economy evolves over
time. The vertical axis shows either employment or an indicator of how much the
economy is producing, such as industrial production or real gross domestic product (real GDP), a measure of the economy’s overall output that we’ll learn about
in the next chapter. As the data in Figure 6-2 suggest, these two measures tend to
move together. Their common movement is the starting point for a major theme
of macroeconomics: the economy’s alternation between short-run downturns and
upturns.
A broad-based downturn, in which output and employment fall in many industries, is called a recession (sometimes referred to as a contraction). Recessions, as
CHAPTER 6
FIGURE 6-3
MACROECONOMICS: THE BIG PICTURE
175
The Business Cycle
This is a stylized picture of the
business cycle. The vertical axis
measures either employment or
total output in the economy. Periods
when these two variables turn down
are recessions; periods when they
turn up are expansions. The point at
which the economy turns down is
a business-cycle peak; the point at
which it turns up again is a businesscycle trough.
Employment
or production
Businesscycle
peaks
Businesscycle
troughs
Year
Recession
officially declared by the National Bureau of Economic Research,
or NBER (discussed in the upcoming For Inquiring Minds), are
indicated by the shaded areas in Figure 6-2. When the economy
isn’t in a recession, when most economic numbers are following
their normal upward trend, the economy is said to be in an expansion (sometimes referred to as a recovery).
The alternation between recessions and expansions is known as
the business cycle. The point in time at which the economy shifts
from expansion to recession is known as a business-cycle peak;
the point at which the economy shifts from recession to expansion
is known as a business-cycle trough.
The business cycle is an enduring feature of the economy.
Table 6-2 shows the official list of business-cycle peaks and
troughs. As you can see, there have been recessions and expansions for at least the past 155 years. Whenever there is a prolonged expansion, as there was in the 1960s and again in the
1990s, books and articles come out proclaiming the end of the
business cycle. Such proclamations have always proved wrong:
the cycle always comes back. But why does it matter?
The Pain of Recession
Not many people complain about the business cycle when the
economy is expanding. Recessions, however, create a great deal
of pain.
The most important effect of a recession is its effect on the
ability of workers to find and hold jobs. The most widely used
indicator of conditions in the labor market is the unemployment
rate. We’ll explain how that rate is calculated in Chapter 8, but
for now it’s enough to say that a high unemployment rate tells us
that jobs are scarce and a low unemployment rate tells us that
jobs are easy to find.
Figure 6-4 shows the unemployment rate from 1988 to 2014. As
you can see, the U.S. unemployment rate surged during and after
each recession but eventually fell during periods of expansion.
Expansion
Recession
TABLE 6-2
The History of the
Business Cycle
Business-Cycle Peak
Business-Cycle Trough
no prior data available
June 1857
October 1860
April 1865
June 1869
October 1873
December 1854
December 1858
June 1861
December 1867
December 1870
March 1879
March 1882
March 1887
July 1890
January 1893
December 1895
May 1885
April 1888
May 1891
June 1894
June 1897
June 1899
September 1902
May 1907
January 1910
January 1913
December 1900
August 1904
June 1908
January 1912
December 1914
August 1918
January 1920
May 1923
October 1926
August 1929
March 1919
July 1921
July 1924
November 1927
March 1933
May 1937
February 1945
November 1948
July 1953
August 1957
June 1938
October 1945
October 1949
May 1954
April 1958
April 1960
December 1969
November 1973
January 1980
July 1981
February 1961
November 1970
March 1975
July 1980
November 1982
July 1990
March 2001
December 2007
March 1991
November 2001
June 2009
Source: National Bureau of Economic Research.
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PA R T 3
INTRODUCTION TO MACROECONOMICS
FIGURE 6-4
The U.S. Unemployment Rate, 1988–2014
The unemployment rate, a measure
of joblessness, rises sharply during
recessions and usually falls during
expansions.
Source: Bureau of Labor Statistics.
Unemployment
rate
11%
10
9
8
7
6
5
4
14
12
20
10
20
08
20
06
20
04
20
02
20
00
20
98
20
96
19
94
19
92
19
90
19
19
19
88
3
“I can’t move in with my parents. They
moved in with my grandparents.”
The rising unemployment rate in 2008 was a sign that a new recession might
be under way, which was later confirmed by the NBER to have begun in
December 2007.
Because recessions cause many people to lose their jobs and also make it
hard to find new ones, recessions hurt the standard of living of many families.
Recessions are usually associated with a rise in the number of people living
below the poverty line, an increase in the number of people who lose their houses
because they can’t afford the mortgage payments, and a fall in the percentage of
Americans with health insurance coverage.
You should not think, however, that workers are the only group that suffers during a recession. Recessions are also bad for firms: like employment and
wages, profits suffer during recessions, with many small businesses failing.
All in all, then, recessions are bad for almost everyone. Can anything be done
to reduce their frequency and severity?
Some readers may be wondering exactly
how recessions and expansions are
defined. The answer is that there is no
exact definition!
In many countries, economists adopt
the rule that a recession is a period of
at least two consecutive quarters (a
quarter is three months) during which the
total output of the economy shrinks. The
two-consecutive-quarters requirement is
designed to avoid classifying brief hiccups in the economy’s performance, with
no lasting significance, as recessions.
Sometimes, however, this definition seems too strict. For example, an
Defining Recessions and Expansions
economy that has three months of sharply
declining output, then three months of
slightly positive growth, then another
three months of rapid decline, should
surely be considered to have endured a
nine-month recession.
In the United States, we try to avoid
such misclassifications by assigning
the task of determining when a recession begins and ends to an independent panel of experts at the National
Bureau of Economic Research
(NBER). This panel looks at a variety
of economic indicators, with the main
focus on employment and produc-
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FOR INQUIRING MINDS
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©Aaron Bacall/www.CartoonStock.com
Year
tion. But, ultimately, the panel makes a
judgment call.
Sometimes this judgment is controversial. In fact, there is lingering controversy
over the 2001 recession. According to
the NBER, that recession began in March
2001 and ended in November 2001
when output began rising. Some critics
argue, however, that the recession really
began several months earlier, when industrial production began falling. Other critics argue that the recession didn’t really
end in 2001 because employment continued to fall and the job market remained
weak for another year and a half.
•
CHAPTER 6
MACROECONOMICS: THE BIG PICTURE
177
Taming the Business Cycle
Modern macroeconomics largely came into being as a response to the worst
recession in history—the 43-month downturn that began in 1929 and continued into 1933, ushering in the Great Depression. The havoc wreaked by the
1929–1933 recession spurred economists to search both for understanding and
for solutions: they wanted to know how such things could happen and how to
prevent them.
As we explained earlier in this chapter, the work of John Maynard Keynes,
published during the Great Depression, suggested that monetary and fiscal
policies could be used to mitigate the effects of recessions, and to this day
governments turn to Keynesian policies when recession strikes. Later work,
notably that of another great macroeconomist, Milton Friedman, led to a
consensus that it’s important to rein in booms as well as to fight slumps. So
modern policy makers try to “smooth out” the business cycle. They haven’t
been completely successful, as a look back at Figure 6-2 makes clear. It’s widely
believed, however, that policy guided by macroeconomic analysis has helped
make the economy more stable.
Although the business cycle is one of the main concerns of macroeconomics
and historically played a crucial role in fostering the development of the field,
macroeconomists are also concerned with other issues. We turn next to the question of long-run growth.
Manufacturing
production index
(2007 = 100)
105
United States
100
95
90
85
20
13
20
12
20
11
Euro Area
80
20
10
his figure shows manufacturing production from 2007
to 2013 in two of the world’s biggest economies: the
United States and the Euro Area, the group of European
countries that share a common currency, the euro. As you
can see, both economies suffered a severe downturn in
2008–2009, probably because banks in both economies
had made many bad loans, and failures on one side of the
Atlantic helped create a crisis of confidence on the other
side as well.
More or less simultaneous recessions in different countries are, in fact, quite common. But that doesn’t mean
that economies always or even usually move in lockstep.
As you can see from the figure, both the Euro Area and
the United States began to recover in mid-2009. In 2011,
however, their paths diverged. The U.S. economy continued to recover steadily, although more slowly than most
would have liked. The Euro Area, by contrast, entered a
new recession in 2011, due to problems of excessive debt
in some countries and a wrong turn in economic policy,
discussed in Chapter 17.
What we learn from recent experience, then, is that
the business cycle is to some extent an international
20
09
T
Slumps Across the Atlantic
20
08
COMPARISION
20
07
GLOBAL
Year
phenomenon. But individual countries can diverge from
each other for a variety of reasons, including policy differences and differences in the underlying structure of their
economies.
Source: Federal Reserve Bank of St. Louis.
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PA R T 3
INTRODUCTION TO MACROECONOMICS
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Comparing Recessions
T
he alternation of recessions and expansions seems to be an enduring feature of economic life. However, not all business cycles are created equal. In
particular, some recessions have been much worse than others.
Let’s compare the two most recent U.S.
FIGURE 6-5
Two U.S. Recessions
recessions: the 2001 recession and the Great
Recession of 2007–2009. These recessions difIndustrial
production as 105%
fered in duration: the first lasted only eight
percentage of
months, the second more than twice as long.
pre-recession
100
Even more important, however, they differed
peak
greatly in depth.
95
2001
In Figure 6-5 we compare the depth of the
recession
90
recessions by looking at what happened to
industrial production over the months after
85
the recession began. In each case, produc2007–2009
80
recession
tion is measured as a percentage of its level
at the recession’s start. Thus the line for the
75
2007–2009 recession shows that industrial
production eventually fell to about 85% of its
8 10 12 14 16 18 20 22 24
2 4
6
0
initial level.
Months after recession began
Clearly, the 2007–2009 recession hit the
Source: Federal Reserve Bank of St. Louis.
economy vastly harder than the 2001 recession. Indeed, by comparison to many recessions, the 2001 slump was very mild.
Of course, this was no consolation to the millions of American workers who
Quick Review
lost their jobs, even in that mild recession.
• The business cycle, the
short-run alternation between
recessions and expansions,
is a major concern of modern
macroeconomics.
• The point at which expansion
shifts to recession is a businesscycle peak. The point at which
recession shifts to expansion is a
business-cycle trough.
Long-run economic growth is
the sustained upward trend in the
economy’s output over time.
Check Your Understanding
6-2
1.
Why do we talk about business cycles for the economy as a whole, rather than just
talking about the ups and downs of particular industries?
2.Describe who gets hurt in a recession, and how.
Solutions appear at back of book.
Long-Run Economic Growth
In 1955, Americans were delighted with the nation’s prosperity. The economy was
expanding, consumer goods that had been rationed during World War II were
available for everyone to buy, and most Americans believed, rightly, that they were
better off than the citizens of any other nation, past or present. Yet by today’s
standards, Americans were quite poor in 1955. Figure 6-6 shows the percentage of
American homes equipped with a variety of appliances in 1905, 1955, and 2005: in
1955 only 37% of American homes contained washing machines and hardly anyone
had air conditioning. And if we turn the clock back another half-century, to 1905,
we find that life for many Americans was startlingly primitive by today’s standards.
Why are the vast majority of Americans today able to afford conveniences
that many Americans lacked in 1955? The answer is long-run economic
growth, the sustained rise in the quantity of goods and services the economy
produces. Figure 6-7 shows the growth between 1900 and 2013 in real GDP per
capita, a measure of total output per person in the economy. The severe recession
of 1929–1933 stands out, but business cycles between World War II and 2007 are
almost invisible, dwarfed by the strong upward trend.
Part of the long-run increase in output is accounted for by the fact that we
have a growing population and workforce. But the economy’s overall production
CHAPTER 6
FIGURE 6-6
The Fruits of Long-Run Growth in America
Percent of
homes with
product
1905
MACROECONOMICS: THE BIG PICTURE
1955
2005
100%
80
60
40
20
El
ec
tri
cit
Te Ran y
l
Au eph ge
to on
mo e
bi
le
El
ec
tri
cit
R
Te an y
le ge
Au ph
t o
Re omo ne
fri bi
ge le
Ai
ra
rc
t
on R or
di ad
tio io
n
Wa ing
sh
Di D er
sh ry
wa er
sh
er
El
ec
tri
cit
R
Te an y
l
Au eph ge
to on
Re mo e
fri bi
ge le
Ai
ra
rc
t
on R or
di ad
tio io
n
Wa ing
sh
e
Co Dis Dr r
lo hw ye
rt a r
el she
e
Mi vis r
cr ion
o
Co wa
m v
Ce pu e
ll te
p r
Di I hon
gi nt e
ta er
l c ne
am t
er
a
0
Americans have become able to afford many more material
goods over time thanks to long-run economic growth.
Source: W. Michael Cox and Richard Alm, “How Are We Doing?” The
American (July/August 2008). http://www.american.com/archive/2008/
july-august-magazine-contents/how-are-we-doing
has increased by much more than the population. On average, in 2013 the U.S.
economy produced about $53,000 worth of goods and services per person, about
twice as much as in 1972, about three times as much as in 1952, and about eight
times as much as in 1900.
Long-run economic growth is fundamental to many of the most pressing economic
questions today. Responses to key policy questions, like the country’s ability to bear the
future costs of government programs such as Social Security and Medicare, depend in
part on how fast the U.S. economy grows over the next few decades.
More broadly, the public’s sense that the country is making progress depends crucially on success in achieving long-run growth. When growth slows, as it did in the
American Growth, the Long View
$50,000
40,000
30,000
20,000
00
20
1
20 0
13
90
20
19
80
70
19
60
19
50
19
40
19
19
30
19
20
19
10
10,000
19
Sources: Angus Maddison, Statistics on
World Population, GDP, and Per Capita
GDP, 1–2008 AD, http://www.ggdc.
net/MADDISON/oriindex.htm; Bureau of
Economic Analysis; The Conference Board
Total Economy Database™, January 2014.
Real GDP
per capita
(2013 dollars)
00
Over the long run, growth in real
GDP per capita in America has
dwarfed the ups and downs of
the business cycle. Except for the
recession that began the Great
Depression, recessions are almost
invisible until 2007.
19
FIGURE 6-7
Year
179
INTRODUCTION TO MACROECONOMICS
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When Did Long-Run Growth Start?
Today, the United States is a much richer country than it was in 1955; in 1955
it was much richer than it had been in
1905. But how did 1855 compare with
1805? Or 1755? How far back does
long-run economic growth go?
The answer is that long-run growth is a
relatively modern phenomenon. The U.S.
economy was already growing steadily
by the mid-nineteenth century—think
railroads. But if you go back to the period
before 1800, you find a world economy
that grew extremely slowly by today’s
standards. Furthermore, the population
grew almost as fast as the economy, so
there was very little increase in output
per person. According to the economic
historian Angus Maddison, from the years
1000 to 1800, real aggregate output
around the world grew less than 0.2%
per year, with population rising at about
the same rate.
Economic stagnation
meant unchanging living
standards. For example,
information on prices and
wages from sources such
as monastery records
shows that workers in
England weren’t significantly better off in the
early eighteenth century
than they had been five
centuries earlier. And
it’s a good bet that they
weren’t much better off
than Egyptian peasants
in the age of the phaEconomic stagnation and unchanging living standards
raohs. However, long-run
prevailed for centuries until the Industrial Revolution in the
economic growth has
mid-1800s ushered in a new era of wealth and sustained
increased significantly
increases in living standards.
since 1800. In the last 50
years or so, real GDP per capita
has grown about 3.5% per year.
Niday Picture Library/Alamy
FOR INQUIRING MINDS
•
1970s, it can help feed a national mood of pessimism. In particular, long-run growth
per capita—a sustained upward trend in output per person—is the key to higher
wages and a rising standard of living. A major concern of macroeconomics—and
the theme of Chapter 9—is trying to understand the forces behind long-run growth.
Long-run growth is an even more urgent concern in poorer, less developed
countries. In these countries, which would like to achieve a higher standard of
living, the question of how to accelerate long-run growth is the central concern
of economic policy.
As we’ll see, macroeconomists don’t use the same models to think about longrun growth that they use to think about the business cycle. It’s always important
to keep both sets of models in mind, because what is good in the long run can be
bad in the short run, and vice versa. For example, we’ve already mentioned the
paradox of thrift: an attempt by households to increase their savings can cause a
recession. But a higher level of savings, as we’ll see in Chapter 10, plays a crucial
role in encouraging long-run economic growth.
in Action
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180
A Tale of Two Countries
M
any countries have experienced long-run growth, but not all have done
equally well. One of the most informative contrasts is between Canada
and Argentina, two countries that, at the beginning of the twentieth century, seemed to be in a good economic position.
From today’s vantage point, it’s surprising to realize that Canada and Argentina
looked rather similar before World War I. Both were major exporters of agricultural
products; both attracted large numbers of European immigrants; both also attracted large amounts of European investment, especially in the railroads that opened
up their agricultural hinterlands. Economic historians believe that the average level
of per capita income was about the same in the two countries as late as the 1930s.
After World War II, however, Argentina’s economy performed poorly, largely
due to political instability and bad macroeconomic policies. Argentina experienced several periods of extremely high inflation, during which the cost of living
CHAPTER 6
MACROECONOMICS: THE BIG PICTURE
soared. Meanwhile, Canada made steady progress. Thanks to the fact that
Canada has achieved sustained long-run growth since 1930, but Argentina has
not, Canada’s standard of living today is almost as high as that of the United
States—and is about three times as high as Argentina’s.
181
Quick Review
• Because the U.S. economy has
Check Your Understanding
6-3
1. Many poor countries have high rates of population growth. What does this imply
about the long-run growth rates of overall output that they must achieve in order
to generate a higher standard of living per person?
2. Argentina used to be as rich as Canada; now it’s much poorer. Does this mean that
Argentina is poorer than it was in the past? Explain.
Solutions appear at back of book.
Inflation and Deflation
achieved long-run economic
growth, Americans live much
better than they did a half-century
or more ago.
• Long-run economic growth
is crucial for many economic
concerns, such as a higher
standard of living or financing
government programs. It’s
especially crucial for poorer
countries.
In January 1980 the average production worker in the United States was paid
$6.57 an hour. By January 2014, the average hourly earnings for such a worker
had risen to $20.18 an hour. Three cheers for economic progress!
But wait. American workers were paid much more in 2014, but they also faced a
much higher cost of living. In January 1980, a dozen eggs cost only about $0.88; by
January 2014, that was up to $2.01. The price of a loaf of white bread went from about
$0.50 to $1.37. And the price of a gallon of gasoline rose from just $1.13 to $3.38.
Figure 6-8 compares the percentage increase in hourly earnings between
1980 and 2014 with the increases in the prices of some standard items: the average worker’s paycheck went farther in terms of some goods, but less far in terms
of others. Overall, the rise in the cost of living wiped out many, if not all, of the
wage gains of the typical American worker from 1980 to 2014. In other words,
once inflation is taken into account, the living standard of the typical American
worker barely rose from 1980 to the present.
The point is that between 1980 and 2014 the economy experienced substantial
inflation: a rise in the overall level of prices. Understanding the causes of inflation and its opposite, deflation—a fall in the overall level of prices—is another
main concern of macroeconomics.
The Causes of Inflation and Deflation
A rising overall level of prices is
inflation.
You might think that changes in the overall level of prices are just a matter of supply
and demand. For example, higher gasoline prices reflect the higher price of crude
A falling overall level of prices is
deflation.
FIGURE 6-8
Rising Prices
Between 1980 and 2014, American
workers’ hourly earnings rose by
207%. But the prices of just about
all the goods bought by workers also
rose, some by more, some by less.
Overall, the rising cost of living offset
most of the rise in the average U.S.
worker’s wage.
Hourly earnings
207%
128%
Eggs
Roast coffee
57%
172%
White bread
Source: Bureau of Labor Statistics.
Gasoline
204%
0
50
100
150
200
250%
Percent increase
182
PA R T 3
INTRODUCTION TO MACROECONOMICS
The economy has price stability
when the overall level of prices
changes slowly or not at all.
oil, and higher crude oil prices reflect such factors as the exhaustion of major oil
fields, growing demand from China and other emerging economies as more people
grow rich enough to buy cars, and so on. Can’t we just add up what happens in each
of these markets to find out what happens to the overall level of prices?
The answer is no, we can’t. Supply and demand can only explain why a particular good or service becomes more expensive relative to other goods and services. It
can’t explain why, for example, the price of chicken has risen over time in spite of the
facts that chicken production has become more efficient (you don’t want to know)
and that chicken has become substantially cheaper compared to other goods.
What causes the overall level of prices to rise or fall? As we’ll learn in Chapter 8,
in the short run, movements in inflation are closely related to the business cycle.
When the economy is depressed and jobs are hard to find, inflation tends to fall;
when the economy is booming, inflation tends to rise. For example, prices of most
goods and services fell sharply during the terrible recession of 1929–1933.
In the long run, by contrast, the overall level of prices is mainly determined
by changes in the money supply, the total quantity of assets that can be readily
used to make purchases. As we’ll see in Chapter 16, hyperinflation, in which prices
rise by thousands or hundreds of thousands of percent, invariably occurs when
governments print money to pay a large part of their bills.
The Pain of Inflation and Deflation
Both inflation and deflation can pose problems for the economy. Here are two
examples: inflation discourages people from holding onto cash, because cash
loses value over time if the overall price level is rising. That is, the amount of
goods and services you can buy with a given amount of cash falls. In extreme
cases, people stop holding cash altogether and turn to barter. Deflation can cause
the reverse problem. If the price level is falling, cash gains value over time. In
other words, the amount of goods and services you can buy with a given amount
of cash increases. So holding on to it can become more attractive than investing
in new factories and other productive assets. This can deepen a recession.
We’ll describe other costs of inflation and deflation in Chapters 8 and 16.
For now, let’s just note that, in general, economists regard price stability—in
which the overall level of prices is changing, if at all, only slowly—as a desirable goal. Price stability is a goal that seemed far out of reach for much of the
American economy during post–World War II period. However, beginning in
the 1990s and continuing to the present, it has been achieved to the satisfaction
of most macroeconomists.
s
ECONOMICS
in Action
A Fast (Food) Measure of Inflation
Everett Collection Inc./Alamy
T
Even though a burger costs 6 times more than it did in 1954
when McDonald’s first opened, it’s still a good bargain compared to other consumer goods.
he original McDonald’s opened in 1954. It offered fast
service—it was, indeed, the original fast-food restaurant. And it was also very inexpensive: hamburgers
cost $0.15, $0.25 with fries. By 2014, a hamburger at a typical
McDonald’s cost more than six times as much, about $1.00.
Has McDonald’s lost touch with its fast-food roots? Have
burgers become luxury cuisine?
No—in fact, compared with other consumer goods, a
burger is a better bargain today than it was in 1954. Burger
prices were about 6.5 times as high in 2013 as they were in
1954. But the consumer price index, the most widely used
measure of the cost of living, was 8.5 times as high in 2013
as it was in 1954.
CHAPTER 6
MACROECONOMICS: THE BIG PICTURE
183
Quick Review
Check Your Understanding
6-4
• A dollar today doesn’t buy what
1.Which of these sound like inflation, which sound like deflation, and which are
ambiguous?
a. Gasoline prices are up 10%, food prices are down 20%, and the prices of most
services are up 1–2%.
b. Gas prices have doubled, food prices are up 50%, and most services seem to be
up 5% or 10%.
c. Gas prices haven’t changed, food prices are way down, and services have gotten
cheaper, too.
it did in 1980, because the prices of
most goods have risen. This rise in
the overall price level has wiped out
most if not all of the wage increases
received by the typical American
worker over the past 34 years.
• One area of macroeconomic
Solutions appear at back of book.
study is in the overall level of
prices. Because either inflation or
deflation can cause problems for
the economy, economists typically
advocate maintaining price
stability.
The United States is an open economy: an economy that trades goods and services with other countries. There have been times when that trade was more or
less balanced—when the United States sold about as much to the rest of the world
as it bought. But this isn’t one of those times.
In 2013, the United States ran a big trade deficit—that is, the value of the
goods and services U.S. residents bought from the rest of the world was a lot
larger than the value of the goods and services American producers sold to customers abroad. Meanwhile, some other countries were in the opposite position,
selling much more to foreigners than they bought.
Figure 6-9 shows the exports and imports of goods for several important
economies in 2013. As you can see, the United States imported much more than
it exported, but Germany, China, and Saudi Arabia did the reverse: they each ran
a trade surplus. A country runs a trade surplus when the value of the goods and
services it buys from the rest of the world is smaller than the value of the goods
and services it sells abroad. Was America’s trade deficit a sign that something
was wrong with our economy—that we weren’t able to make things that people
in other countries wanted to buy?
No, not really. Trade deficits and their opposite, trade surpluses, are macroeconomic phenomena. They’re the result of situations in which the whole is very
different from the sum of its parts. You might think that countries with highly
productive workers or widely desired products and services to sell run trade
surpluses but countries with unproductive workers or poor-quality products and
An open economy is an economy
that trades goods and services with
other countries.
International Imbalances
FIGURE 6-9
A country runs a trade deficit when
the value of goods and services
bought from foreigners is more than
the value of goods and services
it sells to them. It runs a trade
surplus when the value of goods
and services bought from foreigners
is less than the value of the goods
and services it sells to them.
Unbalanced Trade
In 2013, the goods and services
the United States bought from other
countries were worth considerably
more than the goods and services
we sold abroad. Germany, China,
and Saudi Arabia were in the reverse
position. Trade deficits and trade
surpluses reflect macroeconomic
forces, especially differences in savings and investment spending.
Source: CIA World Factbook.
Exports,
imports
(billions)
Exports
Imports
$2,500
2,000
1,500
1,000
500
0
United States Germany
China
Saudi Arabia
184
PA R T 3
INTRODUCTION TO MACROECONOMICS
in Action
RLD VIE
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ECONOMICS
W
services run deficits. But the reality is that there’s no simple relationship between
the success of an economy and whether it runs trade surpluses or deficits.
Microeconomic analysis tells us why countries trade but not why they run
trade surpluses or deficits. In Chapter 2 we learned that international trade is the
result of comparative advantage: countries export goods they’re relatively good
at producing and import goods they’re not as good at producing. That’s why the
United States exports wheat and imports coffee. One important thing the concept
of comparative advantage doesn’t explain, however, is why the value of a country’s
imports is sometimes much larger than the value of its exports, or vice versa.
So what does determine whether a country runs a trade surplus or a trade
deficit? In Chapter 19 we’ll learn the surprising answer: the determinants of the
overall balance between exports and imports lie in decisions about savings and
investment spending—spending on goods like machinery and factories that are
in turn used to produce goods and services for consumers. Countries with high
investment spending relative to savings run trade deficits; countries with low
investment spending relative to savings run trade surpluses.
Spain’s Costly Surplus
I
n 1999 Spain took a momentous step: it gave up its national currency, the peseta, in order to adopt the euro, a shared currency intended to promote closer
economic and political union among the nations of Europe. How did this affect
Spain’s international trade?
Figure 6-10 shows Spain’s current account
Spain’s Current Account Balance,
balance—a
broad definition of its trade balance—
FIGURE 6-10
1999-2013
from 1999 to 2013, measured as a share of gross
domestic product, the country’s total production
Percent
of goods and services. A negative current account
of GDP
balance, as shown here, means the country is run2%
ning a trade deficit. As you can see, after Spain
0
switched to the euro it began running large trade
deficits, which at their peak were more than 10%
–2
of gross domestic product. After 2008, however,
–4
the trade deficit began shrinking rapidly, and by
–6
2013 Spain was running a small surplus.
–8
Did this mean that Spain’s economy was doing
–10
badly in the mid-2000s, and better thereafter?
Just the opposite. When Spain adopted the euro,
1999 2001 2003 2005 2007 2009 2011 2013
foreign investors became highly optimistic about
Year
its prospects, and money poured into the country,
Source: International Monetary Fund.
fueling rapid economic expansion. At the heart
of this expansion was a huge housing boom,
led in particular by the construction of holiday homes along Spain’s famed
Mediterranean coast.
Unfortunately, this epic boom eventually turned into an epic bust, and the
inflows of foreign capital into Spain dried up. One consequence was that Spain
could no longer run large trade deficits, and by 2013 was forced into running
a surplus. Another consequence was a severe recession, leading to very high
unemployment—including the unemployment of Javier Diaz, the jobless graduate
we described at the start of this chapter.
CHAPTER 6
MACROECONOMICS: THE BIG PICTURE
185
Quick Review
Check Your Understanding
6-5
• Comparative advantage can
1. Which of the following reflect comparative advantage, and which reflect macroeconomic forces?
a. Thanks to the development of huge oil sands in the province of Alberta, Canada
has become an exporter of oil and an importer of manufactured goods.
b. Like many consumer goods, the Apple iPod is assembled in China, although
many of the components are made in other countries.
c. Since 2002, Germany has been running huge trade surpluses, exporting much
more than it imports.
d. The United States, which had roughly balanced trade in the early 1990s, began
running large trade deficits later in the decade, as the technology boom took off.
Solutions appear at back of book.
explain why an open economy
exports some goods and services
and imports others, but it can’t
explain why a country imports
more than it exports, or vice versa.
• Trade deficits and trade
surpluses are macroeconomic
phenomena, determined by
decisions about investment
spending and savings.
BUSINESS
CASE
The Business Cycle and the Decline
of Montgomery Ward
Chicago History Museum/Getty Images
B
efore there was the internet, there was mail order, and for rural and smalltown America, what that meant, above all, was the Montgomery Ward
catalog. Starting in 1872, that catalog made it possible for families far from
the big city to buy goods their local store wasn’t likely to stock—everything from
bicycles to pianos. In 1896 Sears, Roebuck and Co. introduced a competing catalog, and the two firms struggled for dominance right up to World War II. After
that, however, Montgomery Ward fell far behind (it finally closed
all its stores in 2000).
Department Store Sales
FIGURE 6-11
Why did Montgomery Ward falter? One key factor
Index, 1919-1946
was that its management misjudged postwar prosU.S. Index
pects. The 1930s were a difficult time for retailers in
(1935-1939 = 100)
general because of the catastrophic economic impact
140
wrought by the Great Depression. Figure 6-11 shows an
index of department store sales, which plunged after
120
1930 and hadn’t fully recovered by 1940. Montgomery
Ward coped with this tough environment by cutting
100
back: it closed some of its stores, cut costs, and accumulated a large hoard of cash. This strategy served the
Great
80
company well, restoring profitability and putting it in
Depression
a very strong financial position.
Unfortunately for the company, it made the mistake
60
of returning to this strategy after World War II—and
the postwar environment was nothing like the envi1919
1924
1929
1934
1939
ronment of the 1930s. Overall department store sales
Year
surged: by 1960 they were more than four times their
Source: National Bureau of Economic Research.
level in 1940. Sears and other retailers expanded to
meet this surge in demand, especially in the rapidly
growing suburbs. But Montgomery Ward, expecting the 1930s to return,
just sat on its cash; it didn’t open any new stores until 1959. By failing to
expand with the market, Montgomery Ward suffered what turned out to
be an irretrievable loss of market share, reputation, and name recognition.
Nothing in business is forever. Eventually Sears too entered a long,
slow decline. First it was overtaken by newer retailers like Walmart,
whose “big box” stores didn’t sell large appliances but generally sold
other goods more cheaply than Sears, in part because Walmart used
information technology to hold costs down. More recently, the rise of
internet sales has hurt traditional retailers of all kinds. But Montgomery
Ward’s self-inflicted defeat in the years after World War II nonetheless
shows how important it is for businesses to understand what is happening in the broader economic environment—that is, to take macroeconomics into account.
QUESTIONS FOR THOUGHT
1. What caused the steep decline in department store sales in the 1930s?
2. In terms of macroeconomics, what was the management of Montgomery
Ward betting would happen after World War II?
3. Economists believe that improvements in our macroeconomic understanding over the course of the 1930s led to better policies thereafter.
If this is true, how did better policies after World War II end up hurting Montgomery Ward?
186
CHAPTER 6
MACROECONOMICS: THE BIG PICTURE
187
SUMMARY
1. Macroeconomics is the study of the behavior of the
economy as a whole, which can be different from the
sum of its parts. Macroeconomics differs from microeconomics in the type of questions it tries to answer.
Macroeconomics also has a strong policy focus:
Keynesian economics, which emerged during the
Great Depression, advocates the use of monetary policy and fiscal policy to fight economic slumps. Prior to
the Great Depression, the economy was thought to be
self-regulating.
2. One key concern of macroeconomics is the business
cycle, the short-run alternation between recessions, periods of falling employment and output, and expansions,
periods of rising employment and output. The point at
which expansion turns to recession is a business-cycle
peak. The point at which recession turns to expansion is
a business-cycle trough.
3. Another key area of macroeconomic study is long-run
economic growth, the sustained upward trend in
the economy’s output over time. Long-run economic
growth is the force behind long-term increases in liv-
ing standards and is important for financing some
economic programs. It is especially important for
poorer countries.
4. When the prices of most goods and services are ris-
ing, so that the overall level of prices is going up, the
economy experiences inflation. When the overall level
of prices is going down, the economy is experiencing
deflation. In the short run, inflation and deflation are
closely related to the business cycle. In the long run,
prices tend to reflect changes in the overall quantity of
money. Because both inflation and deflation can cause
problems, economists and policy makers generally aim
for price stability.
5. Although comparative advantage explains why open
economies export some things and import others,
macroeconomic analysis is needed to explain why
countries run trade surpluses or trade deficits. The
determinants of the overall balance between exports
and imports lie in decisions about savings and investment spending.
KEY TERMS
Self-regulating economy, p. 172
Keynesian economics, p. 172
Monetary policy, p. 172
Fiscal policy, p. 172
Recession, p. 174
Expansion, p. 174
Business cycle, p. 174
Business-cycle peak, p. 174
Business-cycle trough, p. 174
Long-run economic growth, p. 178
Inflation, p. 181
Deflation, p. 181
Price stability, p. 182
Open economy, p. 183
Trade deficit, p. 183
Trade surplus, p. 183
PROBLEMS
1. Which of the following questions are relevant for the
study of macroeconomics and which for microeconomics?
a. How will Ms. Martin’s tips change when a large
manufacturing plant near the restaurant where she
works closes?
b. What will happen to spending by consumers when
the economy enters a downturn?
c. How will the price of oranges change when a late
frost damages Florida’s orange groves?
d. How will wages at a manufacturing plant change
when its workforce is unionized?
e. What will happen to U.S. exports as the dollar
becomes less expensive in terms of other currencies?
f. What is the relationship between a nation’s unem-
ployment rate and its inflation rate?
2. When one person saves more, that person’s wealth is
increased, meaning that he or she can consume more
in the future. But when everyone saves more, everyone’s
income falls, meaning that everyone must consume less
today. Explain this seeming contradiction.
3. Before the Great Depression, the conventional wisdom
among economists and policy makers was that the
economy is largely self-regulating.
a. Is this view consistent or inconsistent with
Keynesian economics? Explain.
b. What effect did the Great Depression have on con-
ventional wisdom?
c. Contrast the response of policy makers during the
2007–2009 recession to the actions of policy makers
during the Great Depression. What would have been
the likely outcome of the 2007–2009 recession if
policy makers had responded in the same fashion as
policy makers during the Great Depression?
188
PA R T 3
INTRODUCTION TO MACROECONOMICS
4. How do economists in the United States determine
9. In 1798, Thomas Malthus’s Essay on the Principle of
when a recession begins and when it ends? How do
other countries determine whether or not a recession is
occurring?
Population was published. In it, he wrote: “Population,
when unchecked, increases in a geometrical ratio.
Subsistence increases only in an arithmetical ratio. . . .
This implies a strong and constantly operating check on
population from the difficulty of subsistence.” Malthus
was saying that the growth of the population is limited
by the amount of food available to eat; people will live
at the subsistence level forever. Why didn’t Malthus’s
description apply to the world after 1800?
5. The U.S. Department of Labor reports statistics on
employment and earnings that are used as key indicators by many economists to gauge the health of the
economy. Figure 6-4 in the text plots historical data
on the unemployment rate each month. Noticeably,
the numbers were high during the recessions in the
early 1990s, in 2001, and in the aftermath of the Great
Recession, 2008–2014.
a. Locate the latest data on the national unemployment
rate. (Hint: Go to the website of the Bureau of Labor
Statistics, www.bls.gov, and locate the latest release
of the Employment Situation.)
10. Each year, The Economist publishes data on the price of
the Big Mac in different countries and exchange rates.
The accompanying table shows some data from 2007
and 2014. Use this information to answer the following
questions.
Country
2007
Price of
Price of
Big Mac
Big Mac
(in local
(in U.S.
currrency)
dollars)
2014
Price of
Price of
Big Mac
Big Mac
(in local
(in U.S.
currency)
dollars)
b. Compare the current numbers with those during the
early 1990s, 2001, and during 2008-2014, as well as
with the periods of relatively high economic growth
just before the recessions. Are the current numbers
indicative of a recessionary trend?
Argentina
peso8.25
$2.65
peso21.0
$2.57
6. In the 1990s there were some dramatic economic events
Canada
C$3.63
$3.08
C$5.25
$5.64
that came to be known as the Asian financial crisis. A
decade later similar events came to be known as the
global financial crisis. The accompanying figure shows
the growth rate of real GDP in the United States and
Japan from 1995 to 2011. Using the graph, explain why
the two sets of events are referred to this way.
Euro area
€2.94
$3.82
€3.68
$4.95
Japan
¥280
$2.31
¥370
$3.64
United States
$3.22
$3.22
$4.80
$4.80
lars in 2007?
b. Where was it cheapest to buy a Big Mac in U.S. dol-
Growth rate
of real GDP
(percent)
lars in 2014?
c. Using the increase in the local currency price of the
United States
6%
4
2
0
–2
Japan
–4
20
09
20
11
20
05
20
07
20
03
20
01
19
97
19
99
–6
19
95
a. Where was it cheapest to buy a Big Mac in U.S. dol-
Big Mac in each country to measure the percent
change in the overall price level from 2007 to 2014,
which nation experienced the most inflation? Did
any of the nations experience deflation?
11. The accompanying figure illustrates the trade deficit of
the United States since 1987. The United States has been
consistently and, on the whole, increasingly importing more goods than it has been exporting. One of the
countries it runs a trade deficit with is China. Which of
the following statements are valid possible explanations
of this fact? Explain.
Year
U.S. trade
deficit
(billions)
7. a.What three measures of the economy tend to move
$800
together during the business cycle? Which way do
they move during an upturn? During a downturn?
700
b.Who in the economy is hurt during a recession? How?
500
c.How did Milton Friedman alter the consensus
400
ent from long-run economic growth? Why do we care
about the size of the long-run growth rate of real GDP
relative to the size of the growth rate of the population?
200
100
11
20
13
20
07
20
03
20
99
19
95
19
91
0
87
8. Why do we consider a business-cycle expansion differ-
300
19
that had developed in the aftermath of the Great
Depression on how the economy should be managed? What is the current goal of policy makers in
managing the economy?
600
19
Source: Federal Reserve Bank of St. Louis.
Year
Source: Federal Reserve Economic Data.
CHAPTER 6
MACROECONOMICS: THE BIG PICTURE
189
a. Many products, such as televisions, that were for-
merly manufactured in the United States are now
manufactured in China.
b. The wages of the average Chinese worker are far
lower than the wages of the average American
worker.
c. Investment spending in the United States is high
relative to its level of savings.
WORK IT OUT
For interactive, step-by-step help in solving the following problem,
visit
by using the URL on the back cover of this book.
12. College tuition has risen significantly in the last few
decades. From the 1981–1982 academic year to the
2011–2012 academic year, total tuition, room, and
board paid by full-time undergraduate students went
from $2,871 to $16,789 at public institutions and
from $6,330 to $33,716 at private institutions. This is
an average annual tuition increase of 6.1% at public
institutions and 5.7% at private institutions. Over the
same time, average personal income after taxes rose
from $9,785 to $39,409 per year, which is an average
annual rate of growth of personal income of 4.8%.
Have these tuition increases made it more difficult
for the average student to afford college tuition?
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CHAPTER
7
RLD VIE
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GDP and the CPI: Tracking
the Macroeconomy
THE NEW #2
s
What You Will Learn
in This Chapter
How economists use
•aggregate
measures to track the
performance of the economy
gross domestic product,
•or What
GDP, is and the three ways of
calculating it
The difference between real
•GDP
and nominal GDP and
why real GDP is the appropriate
measure of real economic activity
a price index is and how it
•is What
used to calculate the inflation
Iain Masterton/Alamy
rate
China has become an economic superpower, surpassing Japan.
“C
HINA PASSES JAPAN AS
Second-Largest Economy.”
That was the headline in the
New York Times on August 15, 2010.
Citing economic data suggesting that
Japan’s economy was weakening while
China’s was roaring ahead, the article
predicted—correctly, as it turned out—
that 2010 would mark the first year in
which the surging Chinese economy
finally overtook Japan’s, taking second
place to the United States on the world
economic stage. “The milestone,” wrote
the Times, “though anticipated for some
time, is the most striking evidence yet
that China’s ascendance is for real and
that the rest of the world will have to reckon with a new economic superpower.”
But what does it mean to say that
China’s economy is larger than Japan’s?
The two economies are, after all, producing very different mixes of goods.
Despite its rapid advance, China is still
a fairly poor country whose greatest
strength is in relatively low-tech production. Japan, by contrast, is very much a
high-tech nation, and it dominates world
output of some sophisticated goods,
like electronic sensors for automobiles.
That’s why the 2011 earthquake in northeastern Japan, which put many factories
out of action, temporarily caused major
production disruptions for auto factories
around the world.
So how can you compare the sizes of
two economies when they aren’t producing the same things?
The answer is that comparisons of
national economies are based on the
value of their production. When news
reports declared that China’s economy
had overtaken Japan’s, they meant
that China’s gross domestic product, or
GDP—a measure of the overall value of
goods and services produced—had surpassed Japan’s GDP.
GDP is one of the most important measures used to track the macroeconomy—
that is, to quantify movements in the overall level of output and prices. Measures
like GDP and price indexes play an important role in formulating economic policy,
since policy makers need to know what’s
going on, and anecdotes are no substitute
for hard data. They’re also important for
business decisions—to such an extent
that, as the business case at the end of the
chapter illustrates, corporations and other
players are willing to pay significant sums
for early reads on what official economic
measurements are likely to find.
In this chapter, we explain how
macroeconomists measure key aspects
of the economy. We first explore ways
to measure the economy’s total output
and total income. We then turn to the
problem of how to measure the level of
prices and the change in prices in the
economy.
191
192 P A R T 3
INTRODUCTION TO MACROECONOMICS
The national income and product
accounts, or national accounts,
keep track of the flows of money
between different sectors of the
economy.
Consumer spending is household
spending on goods and services.
A stock is a share in the ownership
of a company held by a shareholder.
A bond is borrowing in the form of
an IOU that pays interest.
Government transfers are
payments by the government to
individuals for which no good or
service is provided in return.
Disposable income, equal to
income plus government transfers
minus taxes, is the total amount of
household income available to spend
on consumption and to save.
The National Accounts
Almost all countries calculate a set of numbers known as the national income and
product accounts. In fact, the accuracy of a country’s accounts is a remarkably
reliable indicator of its state of economic development—in general, the more reliable the accounts, the more economically advanced the country. When international economic agencies seek to help a less developed country, typically the first
order of business is to send a team of experts to audit and improve the country’s
accounts.
In the United States, these numbers are calculated by the Bureau of Economic
Analysis, a division of the U.S. government’s Department of Commerce. The
national income and product accounts, often referred to simply as the national accounts, keep track of the spending of consumers, sales of producers, business investment spending, government purchases, and a variety of other flows of
money between different sectors of the economy. Let’s see how they work.
The Circular-Flow Diagram, Revisited and Expanded
To understand the principles behind the national accounts, it helps to look at
Figure 7-1, a revised and expanded circular-flow diagram similar to the one we
introduced in Chapter 2. Recall that in Figure 2-7 we showed the flows of money,
goods and services, and factors of production through the economy. Here we
restrict ourselves to flows of money but add extra elements that allow us to show
the key concepts behind the national accounts. As in our original version of the
circular-flow diagram, the underlying principle is that the inflow of money into
each market or sector is equal to the outflow of money coming from that market
or sector.
Figure 2-7 showed a simplified world containing only two kinds of “inhabitants,” households and firms. And it illustrated the circular flow of money between
households and firms, which remains visible in Figure 7-1. In the markets for
goods and services, households engage in consumer spending, buying goods
and services from domestic firms and from firms in the rest of the world.
Households also own factors of production—labor, land, physical capital,
human capital, and financial capital. They sell the use of these factors of production to firms, receiving wages, profit, interest payments, and rent in return. Firms
buy and pay households for the use of those factors of production in the factor
markets. Most households derive the bulk of their income from wages earned by
selling labor and human capital.
But households derive additional income from their indirect ownership of the
physical capital used by firms, mainly in the form of stocks, shares in the ownership of a company, and from direct ownership of bonds, borrowing by firms in
the form of an IOU that pays interest. So the income households receive from the
factor markets includes profits distributed to shareholders known as dividends,
and the interest payments on bonds held by bondholders. Finally, households
receive rent in return for allowing firms to use land or structures that they own.
So households receive income in the form of wages, profit, interest payments, and
rent via factor markets.
In our original, simplified circular-flow diagram, households spent all the
income they received via factor markets on goods and services. Figure 7-1, however, illustrates a more complicated but more realistic diagram. There we see two
reasons why goods and services don’t in fact absorb all of households’ income.
First, households don’t get to keep all the income they receive via the factor
markets. They must pay part of their income to the government in the form of
taxes, such as income taxes and sales taxes. In addition, some households receive
government transfers—payments by the government to individuals for which no
good or service is provided in return, such as Social Security benefits and unemployment insurance payments. The total income households have left after paying
taxes and receiving government transfers is disposable income.
CHAPTER 7
GDP AND THE CPI: TR ACKING THE MACROECONOMY
193
An Expanded Circular-Flow Diagram: The Flows of Money
Through the Economy
FIGURE 7-1
Government purchases of
goods and services
Government borrowing
Government
Taxes
Government transfers
Private savings
Consumer
spending
Households
Wages, profit,
interest, rent
Markets for
goods and
services
Factor
markets
Gross
domestic
product
Investment
spending
Wages, profit,
interest, rent
Borrowing and stock
issues by firms
Firms
Foreign borrowing
and sales of stock
Exports
Imports
Financial
markets
Rest of world
A circular flow of funds connects the four sectors of
the economy—households, firms, government, and the
rest of the world—via three types of markets: the factor
markets, the markets for goods and services, and the
financial markets. Funds flow from firms to households
in the form of wages, profit, interest, and rent through
the factor markets. After paying taxes to the government
and receiving government transfers, households allocate
the remaining income—disposable income—to private
savings and consumer spending. Via the financial
markets, private savings and funds from the rest of the
world are channeled into investment spending by firms,
government borrowing, foreign borrowing and lending,
and foreign transactions of stocks. In turn, funds flow
Foreign lending and
purchases of stock
from the government and households to firms to pay
for purchases of goods and services. Finally, exports to
the rest of the world generate a flow of funds into the
economy and imports lead to a flow of funds out of the
economy. If we add up consumer spending on goods
and services, investment spending by firms, government
purchases of goods and services, and exports, then
subtract the value of imports, the total flow of funds
represented by this calculation is total spending on final
goods and services produced in the United States.
Equivalently, it’s the value of all the final goods and
services produced in the United States—that is, the
gross domestic product of the economy.
Second, households normally don’t spend all of their disposable income on
goods and services. Instead, a portion of their income is typically set aside as
private savings, which goes into financial markets where individuals, banks,
and other institutions buy and sell stocks and bonds as well as make loans. As
Figure 7-1 shows, the financial markets also receive funds from the rest of the
world and provide funds to the government, to firms, and to the rest of the world.
Before going further, we can use the box representing households to illustrate an important general feature of the circular-flow diagram: the total sum
of flows of money out of a given box is equal to the total sum of flows of money
into that box. It’s simply a matter of accounting: what goes in must come out. So,
for example, the total flow of money out of households—the sum of taxes paid,
Private savings, equal to
disposable income minus consumer
spending, is disposable income that
is not spent on consumption.
The banking, stock, and bond
markets, which channel private
savings and foreign lending into
investment spending, government
borrowing, and foreign borrowing,
are known as the financial
markets.
194 P A R T 3
INTRODUCTION TO MACROECONOMICS
Government borrowing is the
total amount of funds borrowed by
federal, state, and local governments
in the financial markets.
Government purchases of goods
and services are total expenditures
on goods and services by federal,
state, and local governments.
Goods and services sold to other
countries are exports. Goods and
services purchased from other
countries are imports.
Inventories are stocks of goods
and raw materials held to facilitate
business operations.
Investment spending is spending
on productive physical capital—such
as machinery and construction
of buildings—and on changes to
inventories.
consumer spending, and private savings—must equal the total flow of money into
households—the sum of wages, profits, interest payments, rent, and government
transfers.
Now let’s look at the other types of inhabitants we’ve added to the circular-flow
diagram, including the government—all federal, state, and local governments—
and the rest of the world. The government returns a portion of the money it collects from taxes to households in the form of government transfers. However, it
uses much of its tax revenue, plus additional funds borrowed in the financial markets through government borrowing, to buy goods and services. Government
purchases of goods and services, the total purchases by federal, state, and local
governments, include everything from military spending on ammunition to your
local public school’s spending on chalk, erasers, and teacher salaries.
The rest of the world participates in the U.S. economy in three ways.
1. Some of the goods and services produced in the United States are sold to
residents of other countries. For example, more than half of America’s annual
wheat and cotton crops are sold abroad. Goods and services sold to other
countries are known as exports. Export sales lead to a flow of funds from the
rest of the world into the United States to pay for them.
2. Some of the goods and services purchased by residents of the United States
are produced abroad. For example, many consumer goods are now made in
China. Goods and services purchased from residents of other countries are
known as imports. Import purchases lead to a flow of funds out of the United
States to pay for them.
3. Foreigners can participate in U.S. financial markets by making transactions.
Foreign lending—lending by foreigners to borrowers in the United States, and
purchases by foreigners of shares of stock in American companies—generates
a flow of funds into the United States from the rest of the world. Conversely,
foreign borrowing—borrowing by foreigners from U.S. lenders and purchases
by Americans of stock in foreign companies—leads to a flow of funds out of
the United States to the rest of the world.
Finally, let’s go back to the markets for goods and services. In Chapter 2 we
focused only on purchases of goods and services by households. We now see that
there are other types of spending on goods and services, including government
purchases, investment spending by firms, imports, and exports.
Notice that firms also buy goods and services in our expanded economy.
For example, an automobile company that is building a new factory will buy
investment goods—machinery like stamping presses and welding robots that
are used to produce goods and services for consumers—from companies that
manufacture these items. It will also accumulate an inventory of finished cars in
preparation for shipment to dealers. Inventories, then, are stocks of goods and
raw materials that firms hold to facilitate their operations. The national accounts
count this investment spending—spending on productive physical capital, such
as machinery and construction of buildings, and on changes to inventories—as
part of total spending on goods and services.
You might ask why changes to inventories are included in investment spending—
finished cars aren’t, after all, used to produce more cars. Changes to inventories
of finished goods are counted as investment spending because, like machinery,
they change the ability of a firm to make future sales. So spending on additions
to inventories is a form of investment spending by a firm. Conversely, a drawingdown of inventories is counted as a fall in investment spending because it leads
to lower future sales.
It’s also important to understand that investment spending includes spending
on construction of any structure, regardless of whether it is an assembly plant or
a new house. Why include construction of homes? Because, like a plant, a new
house produces a future stream of output—housing services for its occupants.
GDP AND THE CPI: TR ACKING THE MACROECONOMY
Suppose we add up consumer spending on goods and services, investment
spending, government purchases of goods and services, and the value of exports,
then subtract the value of imports. This gives us a measure of the overall market
value of the goods and services the economy produces. That measure has a name:
it’s a country’s gross domestic product. But before we can formally define gross
domestic product, or GDP, we have to examine an important distinction between
classes of goods and services: the difference between final goods and services versus intermediate goods and services.
Gross Domestic Product
195
Final goods and services are
goods and services sold to the final,
or end, user.
Intermediate goods and services
are goods and services—bought
from one firm by another firm—that
are inputs for production of final
goods and services.
Gross domestic product, or
GDP, is the total value of all final
goods and services produced in the
economy during a given year.
A consumer’s purchase of a new car from a dealer is one example of a sale of final
goods and services: goods and services sold to the final, or end, user. But an
Aggregate spending, the sum
automobile manufacturer’s purchase of steel from a steel foundry or glass from
of consumer spending, investment
a glassmaker is an example of purchasing intermediate goods and services:
spending, government purchases
of goods and services, and exports
goods and services that are inputs for production of final goods and services. In
minus imports, is the total spending
the case of intermediate goods and services, the purchaser—another firm—is not
on domestically produced final
the final user.
goods and services in the economy.
Gross domestic product, or GDP, is the total value of all final goods and
services produced in an economy during a given period, usually a year. In 2013
the GDP of the United States was $16,800 billion, or about $53,000 per person. If
you are an economist trying to construct a country’s national accounts, one way
to calculate GDP is to calculate it directly: survey firms and add up the total value
of their production of final goods and services. We’ll explain in detail in the next
section why intermediate goods, and some other types of goods as well, are not
included in the calculation of GDP.
But adding up the total value of final goods and services produced isn’t the
only way of calculating GDP. There is another way, based on total spending on
final goods and services. Since GDP is equal to the total value of final goods and
services produced in the economy, it must also equal the flow of funds received
by firms from sales in the goods and services market.
If you look again at the circular-flow diagram in Figure 7-1, you will see that
the arrow going from markets for goods and services to firms is indeed labeled
“Gross domestic product.” According to our basic rule of accounting, flows out of
any box are equal to flows into the box; so the flow of funds out of the markets
for goods and services to firms is equal to the total flow of funds into the markets for goods and services from other sectors. And as you can see from
Figure 7-1, the total flow of funds into the markets for goods and services
is total or aggregate spending on domestically produced final goods and
services—the sum of consumer spending, investment spending, government purchases of goods and services, and exports minus imports. So a
second way of calculating GDP is to add up aggregate spending on domestically produced final goods and services in the economy.
And there is yet a third way of calculating GDP, based on total income
earned in the economy. Firms, and the factors of production that they
employ, are owned by households. So firms must ultimately pay out what
they earn to households. The flow from firms to the factor markets is the
factor income paid out by firms to households in the form of wages, profit,
interest, and rent. Again, by accounting rules, the value of the flow of factor income from firms to households must be equal to the flow of money
into firms from the markets for goods and services. And this last value, we
know, is the total value of production in the economy—GDP.
Why is GDP equal to the total value of factor income paid by firms in the
economy to households? Because each sale in the economy must accrue to
someone as income—either as wages, profit, interest, or rent. So a third way
“You wouldn’t think there’d be much money
of calculating GDP is to sum the total factor income earned by households
in potatoes, chickens, and woodchopping,
from firms in the economy.
but it all adds up.”
© 2005 Frank Cotham from cartoonbank.com. All rights reserved.
CHAPTER 7
196 P A R T 3
INTRODUCTION TO MACROECONOMICS
Calculating GDP
We’ve just explained that there are in fact three methods for calculating GDP:
1. adding up total value of all final goods and services produced
2. adding up spending on all domestically produced goods and services
3. adding up total factor income earned by households from firms in the economy
Government statisticians use all three methods. To illustrate how these three
methods work, we will consider a hypothetical economy, shown in Figure 7-2.
This economy consists of three firms—American Motors, Inc., which produces
one car per year; American Steel, Inc., which produces the steel that goes into the
car; and American Ore, Inc., which mines the iron ore that goes into the steel.
So GDP is $21,500, the value of the one car per year the economy produces. Let’s
look at how the three different methods of calculating GDP yield the same result.
Measuring GDP as the Value of Production of Final Goods and
Services The first method for calculating GDP is to add up the value of all the
final goods and services produced in the economy—a calculation that excludes
the value of intermediate goods and services. Why are intermediate goods and
services excluded? After all, don’t they represent a very large and valuable portion
of the economy?
To understand why only final goods and services are included in GDP, look
at the simplified economy described in Figure 7-2. Should we measure the GDP
of this economy by adding up the total sales of the iron ore producer, the steel
producer, and the auto producer? If we did, we would in effect be counting the
value of the steel twice—once when it is sold by the steel plant to the auto plant,
and again when the steel auto body is sold to a consumer as a finished car. And we
FIGURE 7-2
Calculating GDP
In this hypothetical economy
consisting of three firms, GDP can
be calculated in three different ways:
1) measuring GDP as the value
of production of final goods and
services, by summing each firm’s
value added; 2) measuring GDP as
aggregate spending on domestically
produced final goods and services;
and 3) measuring GDP as factor
income earned by households from
firms in the economy.
2. Aggregate spending on domestically
produced final goods and services = $21,500
Value of sales
Intermediate goods
Wages
Interest payments
Rent
Profit
Total expenditure
by firm
Value added per firm
=
Value of sales – Cost
of intermediate goods
American
Ore, Inc.
American
Steel, Inc.
American Total factor
Motors, Inc.
income
$4,200
(ore)
0
2,000
1,000
200
1,000
4,200
$9,000
(steel)
4,200
(iron ore)
3,700
600
300
200
9,000
$21,500
(car)
9,000
(steel)
10,000
1,000
500
1,000
21,500
4,200
4,800
12,500
1. Value of production of final goods and
services, sum of value added = $21,500
$15,700
2,600
1,000
2,200
3. Total
payments
to factors
= $21,500
GDP AND THE CPI: TR ACKING THE MACROECONOMY
would be counting the value of the iron ore three times—once when it is mined
and sold to the steel company, a second time when it is made into steel and sold
to the auto producer, and a third time when the steel is made into a car and sold
to the consumer.
So counting the full value of each producer’s sales would cause us to count
the same items several times and artificially inflate the calculation of GDP. For
example, in Figure 7-2, the total value of all sales, intermediate and final, is
$34,700: $21,500 from the sale of the car, plus $9,000 from the sale of the steel,
plus $4,200 from the sale of the iron ore. Yet we know that GDP is only $21,500.
The way we avoid double-counting is to count only each producer’s value added
in the calculation of GDP: the difference between the value of its sales and the
value of the intermediate goods and services it purchases from other businesses.
That is, we subtract the cost of inputs—the intermediate goods—at each
stage of the production process. In this case, the value added of the auto producer is the dollar value of the cars it manufactures minus the cost of the steel
it buys, or $12,500. The value added of the steel producer is the dollar value of
the steel it produces minus the cost of the ore it buys, or $4,800. Only the ore
producer, which we have assumed doesn’t buy any inputs, has value added equal
to its total sales, $4,200. The sum of the three producers’ value added is $21,500,
equal to GDP.
Measuring GDP as Spending on Domestically Produced Final Goods
and Services Another way to calculate GDP is by adding up aggregate spending
on domestically produced final goods and services. That is, GDP can be measured
by the flow of funds into firms. Like the method that estimates GDP as the value
of domestic production of final goods and services, this measurement must be
carried out in a way that avoids double-counting.
In terms of our steel and auto example, we don’t want to count both consumer
spending on a car (represented in Figure 7-2 by $12,500, the sales price of the car)
and the auto producer’s spending on steel (represented in Figure 7-2 by $9,000, the
price of a car’s worth of steel). If we counted both, we would be counting the steel
embodied in the car twice. We solve this problem by counting only the value of
sales to final buyers, such as consumers, firms that purchase investment goods, the
government, or foreign buyers. In other words, in order to avoid double-counting
An old line says that when a person marries the household cook, GDP falls. And
it’s true: when someone provides services for pay, those services are counted
as a part of GDP. But the services family
members provide to each other are not.
Some economists have produced alternative measures that try to “impute” the
value of household work—that is, assign
an estimate of what the market value of
that work would have been if it had been
paid for. But the standard measure of
GDP doesn’t contain that imputation.
GDP estimates do, however, include
an imputation for the value of “owneroccupied housing.” That is, if you buy
the home you were formerly renting,
GDP does not go down. It’s true that
Steel is an intermediate good
because it is sold to other product
manufacturers like automakers, and
rarely to final buyers, such as
consumers.
The value added of a producer is
the value of its sales minus the value
of its purchases of intermediate
goods and services.
Our Imputed Lives
Glenda/Shutterstock
FOR INQUIRING MINDS
197
Mircea Bezergheanu/Shutterstock
CHAPTER 7
The value of the services that family members provide to each other is not counted
as part of GDP.
because you no longer pay rent to your
landlord, the landlord no longer sells a
service to you—namely, use of the house
or apartment. But the statisticians make
an estimate of what you would have paid
if you rented whatever you live in, whether it’s an apartment or a house. For the
purposes of the statistics, it’s as if you
were renting your dwelling from yourself.
If you think about it, this makes a lot
of sense. In a home-owning country like
the United States, the pleasure we derive
from our houses is an important part of
the standard of living. So to be accurate,
estimates of GDP must take into account
the value of housing that is occupied
by owners as well as the value of rental
housing.
•
198 P A R T 3
INTRODUCTION TO MACROECONOMICS
of spending, we omit sales of inputs from one business to another when estimating
GDP using spending data. You can see from Figure 7-2 that aggregate spending on
final goods and services—the finished car—is $21,500.
As we’ve already pointed out, the national accounts do include investment
spending by firms as a part of final spending. That is, an auto company’s purchase of steel to make a car isn’t considered a part of final spending, but the
company’s purchase of new machinery for its factory is considered a part of final
spending. What’s the difference? Steel is an input that is used up in production;
machinery will last for a number of years. Since purchases of capital goods that
will last for a considerable time aren’t closely tied to current production, the
national accounts consider such purchases a form of final sales.
In later chapters, we will make use of the proposition that GDP is equal to
aggregate spending on domestically produced goods and services by final buyers.
We will also develop models of how final buyers decide how much to spend. With
that in mind, we’ll now examine the types of spending that make up GDP.
Look again at the markets for goods and services in Figure 7-1, and you will
see that one component of sales by firms is consumer spending. Let’s denote
consumer spending with the symbol C. Figure 7-1 also shows three other components of sales: sales of investment goods to other businesses, or investment
spending, which we will denote by I; government purchases of goods and services,
which we will denote by G; and sales to foreigners—that is, exports—which we
will denote by X.
In reality, not all of this final spending goes toward domestically produced
goods and services. We must take account of spending on imports, which we
will denote by IM. Income spent on imports is income not spent on domestic
goods and services—it is income that has “leaked” across national borders. So to
accurately value domestic production using spending data, we must subtract out
spending on imports to arrive at spending on domestically produced goods and
services. Putting this all together gives us the following equation that breaks GDP
down by the four sources of aggregate spending:
(7-1) GDP = C + I + G + X − IM
We’ll be seeing a lot of Equation 7-1 in later chapters.
P I T FA L L S
GDP: WHAT’S IN AND WHAT’S OUT
It’s easy to confuse what is included in
and what is excluded from GDP. So
let’s stop here for a moment and make
sure the distinction is clear. The most
likely source of confusion is the difference between investment spending
and spending on intermediate goods
and services. Investment spending—
spending on productive physical capital
(including construction of residential and
commercial structures), and changes
to inventories—is included in GDP. But
spending on intermediate goods and
services is not.
Why the difference? Recall from
Chapter 2 that we made a distinction
between resources that are used up and
those that are not used up in production.
An input, like steel, is used up in production. An investment good, like a metalstamping machine, is not. It will last for
many years and will be used repeatedly
to make many cars. Since spending on
productive physical capital—investment
goods—and construction of structures
is not directly tied to current output,
economists consider such spending to
be spending on final goods.
Spending on changes to inventories is considered a part of investment
spending, so it is also included in GDP.
Why? Because, like a machine, additional inventory is an investment in future
sales. And when a good is released for
sale from inventories, its value is subtracted from the value of inventories and
so from GDP.
Used goods are not included in GDP
because, as with inputs, to include them
would be to double-count: counting
them once when sold as new and again
when sold as used.
Also, financial assets such as stocks
and bonds are not included in GDP
because they don’t represent either the
production or the sale of final goods
and services. Rather, a bond represents
a promise to repay with interest, and
a stock represents a proof of ownership. And for obvious reasons, foreignproduced goods and services are not
included in calculations of GDP.
Here is a summary of what’s included
and not included in GDP:
Included
n
Domestically produced final goods
and services, including capital goods,
new construction of structures, and
changes to inventories
Not Included
n
Intermediate goods and services
n
Inputs
n
Used goods
n
Financial assets like stocks and bonds
n
Foreign-produced goods and services
CHAPTER 7
GDP AND THE CPI: TR ACKING THE MACROECONOMY
199
Measuring GDP as Factor Income Earned from Firms in the Economy A
final way to calculate GDP is to add up all the income earned by factors of production from firms in the economy—the wages earned by labor; the interest paid
to those who lend their savings to firms and the government; the rent earned by
those who lease their land or structures to firms; and dividends, the profits paid
to the shareholders, the owners of the firms’ physical capital. This is a valid measure because the money firms earn by selling goods and services must go somewhere; whatever isn’t paid as wages, interest, or rent is profit. Ultimately, profits
are paid out to shareholders as dividends.
Figure 7-2 shows how this calculation works for our simplified economy. The
numbers shaded in the column at far right show the total wages, interest, and rent
paid by all these firms as well as their total profit. Summing up all of these items
yields total factor income of $21,500—again, equal to GDP.
We won’t emphasize factor income as much as the other two methods of
calculating GDP. It’s important to keep in mind, however, that all the money
spent on domestically produced goods and services generates factor income to
households—that is, there really is a circular flow.
The Components of GDP Now that we know how GDP is calculated in principle, let’s see what it looks like in practice.
Figure 7-3 shows the first two methods of calculating GDP side by side. The
height of each bar above the horizontal axis represents the GDP of the U.S.
economy in 2013: $16,800 billion. Each bar is divided to show the breakdown of
that total in terms of where the value was added and how the money was spent.
FIGURE 7-3
U.S. GDP in 2013: Two Methods of Calculating GDP
The two bars show two equivalent
ways of calculating GDP. The height
of each bar above the horizontal axis
represents $16,800 billion, U.S.
GDP in 2013. The left bar shows the
breakdown of GDP according to the
value added of each sector of the
economy: government, households,
and firms. The right bar shows the
breakdown of GDP according to the
four types of aggregate spending:
C + I + G + X − IM. The right bar
has a total length of $16,800 billion
+ $497 billion = $17,297 billion.
The $497 billion, shown as the
area extending below the horizontal
axis, is the amount of total spending
absorbed by net exports, which were
negative in 2013. (Numbers don’t
add due to rounding.)
Components of GDP (billions of dollars)
$20,000
Value added by sector
15,000
Value added by government
= $2,036 (12.1%)
Value added by households
= $2,079 (12.4%)
Spending on domestically
produced final goods
and services
Government purchases
of goods and services
G = $3,126 (18.6%)
Investment spending
I = $2,670 (15.9%)
10,000
C+I+G
= $16,800
5,000
Value added
by business
= $12,684 (75.5%)
Consumer spending
C = $11,502 (68.4%)
Source: Bureau of Economic Analysis.
0
Net exports X – IM = –$497 (–3.0%)
INTRODUCTION TO MACROECONOMICS
In the left bar in Figure 7-3, we see the breakdown of GDP by value added
according to sector, the first method of calculating GDP. Of the $16,800 billion,
$12,684 billion consisted of value added by businesses. Another $2,079 billion of
value added was added by households and institutions; a large part of that was
the imputed services of owner-occupied housing, described in the earlier For
Inquiring Minds “Our Imputed Lives.” Finally, $2,036 billion consisted of value
added by government, in the form of military, education, and other government
services.
The right bar in Figure 7-3 corresponds to the second method of calculating
GDP, showing the breakdown by the four types of aggregate spending. The total
length of the right bar is longer than the total length of the left bar, a difference of
$497 billion (which, as you can see, is the amount by which the right bar extends
below the horizontal axis). That’s because the total length of the right bar represents total spending in the economy, spending on both domestically produced
and foreign-produced final goods and services. Within the bar, consumer spending (C), which is 68.4% of GDP, dominates overall spending.
But some of that spending was absorbed by foreign-produced goods and
services. In 2013, net exports, the difference between the value of exports and
the value of imports (X − IM in Equation 7-1) was negative—the United States
was a net importer of foreign goods and services. The 2013 value of X − IM was
−$497 billion, or −3.0% of GDP. Thus, a portion of the right bar extends below
the horizontal axis by $497 billion to represent the amount of total spending that
was absorbed by net imports and so did not lead to higher U.S. GDP. Investment
spending (I) constituted 15.9% of GDP; government purchases of goods and services (G) constituted 18.6% of GDP.
Occasionally you may see references
not to gross domestic product but to
gross national product, or GNP. Is this
just another name for the same thing?
Not quite.
If you look at Figure 7-1 carefully, you
may realize that there’s a possibility that
is missing from the figure. According
to the figure, all factor income goes to
domestic households. But what happens
when profits are paid to foreigners who
own stock in General Motors or Apple?
And where do the profits earned by
American companies operating overseas
fit in?
To answer these questions, an alternative measure, GNP, was devised.
GNP is defined as the total factor
income earned by residents of a country. It excludes factor income earned by
foreigners, like profits paid to foreign
investors who own American stocks
and payments to foreigners who work
temporarily in the United States. And it
includes factor income earned abroad
by Americans, like the profits of Apple’s
European operations that accrue to
Apple’s American shareholders and the
Gross What?
W
FOR INQUIRING MINDS
RLD VIE
O
wages of Americans who work abroad
temporarily.
In the early days of national income
accounting, economists usually used
GNP rather than GDP as a measure of
the economy’s size—although the measures were generally very close to each
other. They switched to GDP mainly
because it’s considered a better indicator of short-run movements in production and because data on international
flows of factor income are considered
somewhat unreliable.
In practice, it doesn’t make much
difference which measure is used for
large economies like that of the United
States, where the flows of net factor
income to other countries are relatively
small. In 2013, America’s GNP was
about 1.5% larger than its GDP, mainly
because of the overseas profit of U.S.
companies. However, for smaller countries, which are likely to be hosts to a
number of foreign companies, GDP
and GNP can diverge significantly. For
example, much of Ireland’s industry
is owned by American corporations,
whose profit must be deducted from
Age Fotostock/SuperStock
Net exports are the difference
between the value of exports and the
value of imports.
W
200 P A R T 3
GNP, the value of output produced within
a country’s borders, typically differs from
GDP, the value of output produced worldwide that is owned by a country’s citizens
and firms.
Ireland’s GNP. In addition, Ireland has
become a host to many temporary
workers from poorer regions of Europe,
whose wages must also be deducted
from Ireland’s GNP. As a result, in
2013 Ireland’s GNP was only 86% of
its GDP.
•
CHAPTER 7
GDP AND THE CPI: TR ACKING THE MACROECONOMY
201
What GDP Tells Us
Now we’ve seen the various ways that gross domestic product is calculated. But
what does the measurement of GDP tell us?
The most important use of GDP is as a measure of the size of the economy,
providing us a scale against which to measure the economic performance of
other years or to compare the economic performance of other countries. For
example, suppose you want to compare the economies of different nations. A
natural approach is to compare their GDPs. In 2013, as we’ve seen, U.S. GDP was
$16,800 billion, China’s GDP was $9,181 billion, and the combined GDP of the 27
countries that make up the European Union was $17,371 billion. This comparison
tells us that China, although it has the world’s second-largest national economy,
carries considerably less economic weight than does the United States. When
taken in aggregate, Europe is America’s equal or superior.
Still, one must be careful when using GDP numbers, especially when making
comparisons over time. That’s because part of the increase in the value of GDP
over time represents increases in the prices of goods and services rather than an
increase in output. For example, U.S. GDP was $8,608 billion in 1997 and had
approximately doubled to $16,800 billion by 2013. But the U.S. economy didn’t
actually double in size over that period. To measure actual changes in aggregate
output, we need a modified version of GDP that is adjusted for price changes,
known as real GDP. We’ll see next how real GDP is calculated.
Quick Review
s
ECONOMICS
• A country’s national income
in Action
and product accounts, or
national accounts, track flows of
money among economic sectors.
Creating the National Accounts
T
he national accounts, like modern macroeconomics, owe their creation to
the Great Depression. As the economy plunged into depression, government officials found their ability to respond crippled not only by the lack
of adequate economic theories but also by the lack of adequate information. All
they had were scattered statistics: railroad freight car loadings, stock prices, and
incomplete indexes of industrial production. They could only guess at what was
happening to the economy as a whole.
In response to this perceived lack of information, the Department of Commerce
commissioned Simon Kuznets, a young Russian-born economist, to develop a set of
national income accounts. (Kuznets later won the Nobel Prize in economics for his
work.) The first version of these accounts was presented to Congress in 1937 and in
a research report titled National Income, 1929–35.
Kuznets’s initial estimates fell short of the full modern set of accounts because
they focused on income, not production. The push to complete the national accounts
came during World War II, when policy makers were in even more need of comprehensive measures of the economy’s performance. The federal government began
issuing estimates of gross domestic product and gross national product in 1942.
In January 2000, in its publication Survey of Current Business, the Department
of Commerce ran an article titled “GDP: One of the Great Inventions of the 20th
Century.” This may seem a bit over the top, but national income accounting,
invented in the United States, has since become a tool of economic analysis and
policy making around the world.
Check Your Understanding
7-1
1. Explain why the three methods of calculating GDP produce the same estimate of GDP.
2. What are the various sectors to which firms make sales? What are the various ways
in which households are linked with other sectors of the economy?
3. Consider Figure 7-2 and suppose you mistakenly believed that total value added
was $30,500, the sum of the sales price of a car and a car’s worth of steel. What
items would you be counting twice?
Solutions appear at back of book.
• Households receive factor
income in the form of wages,
profit from ownership of stocks,
interest paid on bonds, and rent.
They also receive government
transfers.
• Households allocate disposable
income between consumer
spending and private savings—
funds that flow into the financial
markets, financing investment
spending and any government
borrowing.
• Government purchases of
goods and services are total
expenditures by federal, state, and
local governments on goods and
services.
• Exports lead to a flow of funds
into the country. Imports lead to
a flow of funds out of the country.
• Gross domestic product,
or GDP, can be calculated in
three different ways: add up the
value added by all firms; add
up all spending on domestically
produced final goods and
services, an amount equal to
aggregate spending; or add up
all factor income paid by firms.
Intermediate goods and services
are not included in the calculation
of GDP, while changes in
inventories and net exports are.
202 P A R T 3
INTRODUCTION TO MACROECONOMICS
Aggregate output is the economy’s
total quantity of output of final goods
and services.
Real GDP is the total value of all
final goods and services produced
in the economy during a given year,
calculated using the prices of a
selected base year.
Real GDP: A Measure of Aggregate Output
In this chapter’s opening story, we described how China passed Japan as the
world’s second-largest economy in 2010. At the time, Japan’s economy was weakening: during the second quarter of 2010, output declined by an annual rate of
6.3%. Oddly, however, GDP was up. In fact, Japan’s GDP measured in yen, its
national currency, rose by an annual rate of 4.8% during the quarter. How was
that possible? The answer is that Japan was experiencing inflation at the time. As
a result, the yen value of Japan’s GDP rose although output actually fell.
The moral of this story is that the commonly cited GDP number is an interesting and useful statistic, one that provides a good way to compare the size of
different economies, but it’s not a good measure of the economy’s growth over
time. GDP can grow because the economy grows, but it can also grow simply
because of inflation. Even if an economy’s output doesn’t change, GDP will go
up if the prices of the goods and services the economy produces have increased.
Likewise, GDP can fall either because the economy is producing less or because
prices have fallen.
In order to accurately measure the economy’s growth, we need a measure of
aggregate output: the total quantity of final goods and services the economy
produces. The measure that is used for this purpose is known as real GDP. By
tracking real GDP over time, we avoid the problem of changes in prices distorting
the value of changes in production of goods and services over time. Let’s look first
at how real GDP is calculated, then at what it means.
Calculating Real GDP
To understand how real GDP is calculated, imagine an economy in which only
two goods, apples and oranges, are produced and in which both goods are sold
only to final consumers. The outputs and prices of the two fruits for two consecutive years are shown in Table 7-1.
The first thing we can say about these data is
Calculating GDP and Real GDP in a
that
the value of sales increased from year 1 to
TABLE 7-1
Simple Economy
year 2. In the first year, the total value of sales
Year 1
Year 2
was (2,000 billion × $0.25) + (1,000 billion × $0.50)
Quantity of apples (billions)
2,000
2,200
= $1,000 billion; in the second it was (2,200 billion
× $0.30) + (1,200 billion × $0.70) = $1,500 billion,
Price of apple
$0.25
$0.30
which is 50% larger. But it is also clear from
Quantity of oranges (billions)
1,000
1,200
the table that this increase in the dollar value of
Price of orange
$0.50
$0.70
GDP overstates the real growth in the economy.
GDP (billions of dollars)
$1,000
$1,500
Although the quantities of both apples and oranges increased, the prices of both apples and orangReal GDP (billions of year 1 dollars)
$1,000
$1,150
es also rose. So part of the 50% increase in the
dollar value of GDP from year 1 to year 2 simply
reflects higher prices, not higher production of output.
To estimate the true increase in aggregate output produced, we have to ask
the following question: how much would GDP have gone up if prices had not
changed? To answer this question, we need to find the value of output in year 2
expressed in year 1 prices. In year 1 the price of apples was $0.25 each and the
price of oranges $0.50 each. So year 2 output at year 1 prices is (2,200 billion ×
$0.25) + (1,200 billion × $0.50) = $1,150 billion. And output in year 1 at year 1
prices was $1,000 billion. So in this example GDP measured in year 1 prices rose
15%—from $1,000 billion to $1,150 billion.
Now we can define real GDP: it is the total value of final goods and services
produced in the economy during a year, calculated as if prices had stayed constant at the level of some given base year. A real GDP number always comes with
information about what the base year is.
CHAPTER 7
GDP AND THE CPI: TR ACKING THE MACROECONOMY
203
A GDP number that has not been adjusted for changes in prices is calculated
using the prices in the year in which the output is produced. Economists call this
measure nominal GDP, GDP at current prices. If we had used nominal GDP to
measure the true change in output from year 1 to year 2 in our apples and oranges example, we would have overstated the true growth in output: we would have
claimed it to be 50%, when in fact it was only 15%. By comparing output in the
two years using a common set of prices—the year 1 prices in this example—we
are able to focus solely on changes in the quantity of output by eliminating the
influence of changes in prices.
Nominal versus Real GDP in
Table 7-2 shows a real-life version of our apples
TABLE 7-2
and oranges example. The second column shows nomi2005, 2009, and 2013
nal GDP in 2005, 2009, and 2013. The third column
Nominal GDP (billions of Real GDP (billions
shows real GDP for each year in 2009 dollars. For
current dollars)
of 2009 dollars)
2009 the two numbers are the same. But real GDP in
$14,234
2005
$13,094
2005 expressed in 2009 dollars was higher than nomi2009
14,419
14,419
nal GDP in 2005, reflecting the fact that prices were
2013
16,768
15,710
in general higher in 2009 than in 2005. Real GDP in
2013 expressed in 2009 dollars, however, was less than
nominal GDP in 2013 because prices in 2009 were lower than in 2013.
You might have noticed that there is an alternative way to calculate real
GDP using the data in Table 7-1. Why not measure it using the prices of year 2
rather than year 1 as the base-year prices? This procedure seems equally valid.
According to that calculation, real GDP in year 1 at year 2 prices is (2,000 billion ×
$0.30) + (1,000 billion × $0.70) = $1,300 billion; real GDP in year 2 at year 2 prices
is $1,500 billion, the same as nominal GDP in year 2. So using year 2 prices as
the base year, the growth rate of real GDP is equal to ($1,500 billion − $1,300 billion)/$1,300 billion = 0.154, or 15.4%. This is slightly higher than the figure we got
from the previous calculation, in which year 1 prices were the base-year prices. In
that calculation, we found that real GDP increased by 15%. Neither answer, 15.4%
versus 15%, is more “correct” than the other.
In reality, the government economists who put together the U.S. national
accounts have adopted a method to measure the change in real GDP known as
chain-linking, which uses the average between the GDP growth rate calculated
using an early base year and the GDP growth rate calculated using a late base
year. As a result, U.S. statistics on real GDP are always expressed in chained
dollars.
What Real GDP Doesn’t Measure
GDP, nominal or real, is a measure of a country’s aggregate output. Other things
equal, a country with a larger population will have higher GDP simply because
there are more people working. So if we want to compare GDP across countries
but want to eliminate the effect of differences in population size, we use the measure GDP per capita—GDP divided by the size of the population, equivalent to
the average GDP per person.
Real GDP per capita can be a useful measure in some circumstances, such as
in a comparison of labor productivity between countries. However, despite the
fact that it is a rough measure of the average real output per person, real GDP per
capita has well-known limitations as a measure of a country’s living standards.
Every once in a while economists are accused of believing that growth in real GDP
per capita is the only thing that matters—that is, thinking that increasing real
GDP per capita is a goal in itself. In fact, economists rarely make that mistake; the
idea that economists care only about real GDP per capita is a sort of urban legend.
Let’s take a moment to be clear about why a country’s real GDP per capita is
not a sufficient measure of human welfare in that country and why growth in real
GDP per capita is not an appropriate policy goal in itself.
Nominal GDP is the value of all
final goods and services produced
in the economy during a given year,
calculated using the prices current
in the year in which the output is
produced.
Chained dollars is the method of
calculating changes in real GDP
using the average between the
growth rate calculated using an
early base year and the growth rate
calculated using a late base year.
GDP per capita is GDP divided
by the size of the population; it is
equivalent to the average GDP per
person.
204 P A R T 3
INTRODUCTION TO MACROECONOMICS
GLOBAL
COMPARISION
GDP and the Meaning of Life
“I
’ve been rich and I’ve been poor,” the actress Mae West
famously declared. “Believe me, rich is better.” But is the
same true for countries?
This figure shows two pieces of information for a number
of countries: how rich they are, as measured by GDP per
capita, and how people assess their well-being. Well-being
was measured by a Gallup world survey that asked people
to rate their lives at the current time and their expectations
for the next five years. The graph shows the percentage of
people who rated their well-being as “thriving.” The figure
seems to tell us three things:
and smaller. For example, the rise in GDP per capita
from lower-income Italy to middle-income Belgium
is about the same as from middle-income Belgium
to the high-income United States. But the increase
in life satisfaction is much greater going from Italy
to Belgium compared to going from Belgium to the
United States.
3. Money isn’t everything. Israelis, though rich by world
standards, are poorer than Americans—but they seem
more satisfied with their lives. Japan is richer than
most other nations, but by and large quite miserable.
1. Rich is better. Richer countries on average have high-
These results are consistent with the observation that
high GDP per capita makes it easier to achieve a good life
but that countries aren’t equally successful in taking advantage of that possibility.
er well-being than poor countries.
2. Money matters less as you grow richer. As GDP
rises, the average gain in life satisfaction gets smaller
Percent of population
reporting “thriving”
well-being
80%
Israel
60
Finland
Belgium
40
France
Italy
Portugal
0 $10,000
20,000
Netherlands
Austria
Germany
Spain
20
United Sweden
Kingdom
Denmark
Canada
Hong Kong
30,000
Ireland
United
States
Singapore
Japan
40,000
50,000
GDP per capita (U.S. dollars)
Source: Gallup; World Bank.
One way to think about this issue is to say that an increase in real GDP means
an expansion in the economy’s production possibility frontier. Because the economy has increased its productive capacity, society can achieve more things. But
whether society actually makes good use of that increased potential to improve
living standards is another matter. To put it in a slightly different way, your
income may be higher this year than last year, but whether you use that higher
income to improve your quality of life is your choice.
So let’s say it again: real GDP per capita is a measure of an economy’s average
aggregate output per person—and so of what it can do. It is not a sufficient goal
in itself because it doesn’t address how a country uses that output to affect living
standards. A country with a high GDP can afford to be healthy, to be well educated, and in general to have a good quality of life. But there is not a one-to-one
match between GDP and the quality of life.
CHAPTER 7
W
in Action
205
RLD VIE
O
W
s
ECONOMICS
GDP AND THE CPI: TR ACKING THE MACROECONOMY
Miracle in Venezuela?
T
he South American nation
of Venezuela has a distinction that may surprise you:
in recent years, it has had one of
the world’s fastest-growing nominal GDPs. Between 2000 and 2013,
Venezuelan nominal GDP grew by
an average of 29% each year—much
faster than nominal GDP in the
United States or even in booming
economies like China.
So is Venezuela experiencing an
economic miracle? No, it’s just suffering from unusually high inflation.
Figure 7-4 shows Venezuela’s nominal and real GDP from 2000 to 2013,
with real GDP measured in 1997
prices. Real GDP did grow over the
period, but at an annual rate of only
3.2%. That’s about twice the U.S.
growth rate over the same period, but
it is far short of China’s 10% growth.
Check Your Understanding
FIGURE 7-4
Real versus Nominal GDP in Venezuela
Nominal GDP
(billions of bolivars),
Real GDP (billions
of 1997 bolivars)
VEB 2,500
2,000
1,500
Nominal
GDP
1,000
Real
GDP
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
20
13
500
Year
Source:
IMF—World
Economic
Outlook (2014).
Source:
IMF–World
Economic
Outlook (2014).
Quick Review
• To determine the actual growth
7-2
1.Assume there are only two goods in the economy, french fries and onion rings. In
2013, 1,000,000 servings of french fries were sold at $0.40 each and 800,000 servings of onion rings at $0.60 each. From 2013 to 2014, the price of french fries rose
by 25% and the servings sold fell by 10%; the price of onion rings fell by 15% and
the servings sold rose by 5%.
a. Calculate nominal GDP in 2013 and 2014. Calculate real GDP in 2014 using 2013
prices.
b. Why would an assessment of growth using nominal GDP be misguided?
2.From 2005 to 2010, the price of electronic equipment fell dramatically and the
price of housing rose dramatically. What are the implications of this in deciding
whether to use 2005 or 2010 as the base year in calculating 2013 real GDP?
Solutions appear at back of book.
Price Indexes and the Aggregate Price Level
In the spring and summer of 2011, Americans were facing sticker shock at the
gas pump: the price of a gallon of regular gasoline had risen from an average of
$1.61 at the end of December 2008 to close to $4. Many other prices were also up.
Some prices, though, were heading down: some foods, like eggs, were coming
down from a run-up in late 2010, and virtually anything involving electronics was
getting cheaper as well. Yet practically everyone felt that the overall cost of living
was rising. But how fast?
Clearly, there was a need for a single number summarizing what was happening to consumer prices. Just as macroeconomists find it useful to have a single
number representing the overall level of output, they also find it useful to have
in aggregate output, we calculate
real GDP using prices from
some given base year. In contrast,
nominal GDP is the value of
aggregate output calculated with
current prices. U.S. statistics on
real GDP are always expressed in
chained dollars.
• Real GDP per capita is a
measure of the average aggregate
output per person. But it is not
a sufficient measure of human
welfare, nor is it an appropriate
goal in itself, because it does not
reflect important aspects of living
standards within an economy.
206 P A R T 3
INTRODUCTION TO MACROECONOMICS
The aggregate price level is a
measure of the overall level of prices
in the economy.
A market basket is a hypothetical
set of consumer purchases of goods
and services.
A price index measures the cost
of purchasing a given market basket
in a given year, where that cost is
normalized so that it is equal to 100
in the selected base year.
a single number representing the overall level of prices: the aggregate price
level. Yet a huge variety of goods and services are produced and consumed in the
economy. How can we summarize the prices of all these goods and services with
a single number? The answer lies in the concept of a price index—a concept best
introduced with an example.
Market Baskets and Price Indexes
Suppose that a frost in Florida destroys most of the citrus harvest. As a result, the
price of an orange rises from $0.20 to $0.40, the price of a grapefruit rises from
$0.60 to $1.00, and the price of a lemon rises from $0.25 to $0.45. How much has
the price of citrus fruit increased?
One way to answer that question is to state three numbers—the changes in
prices for oranges, grapefruit, and lemons. But this is a very cumbersome method. Rather than having to recite three numbers in an effort to track changes in
the prices of citrus fruit, we would prefer to have some kind of overall measure
of the average price change.
To measure average price changes for consumer goods and services, economists track changes in the cost of a typical consumer’s consumption bundle—the
typical basket of goods and services purchased before the price changes. A hypothetical consumption bundle, used to measure changes in the overall price level,
is known as a market basket. Suppose that before the frost a typical consumer
bought 200 oranges, 50 grapefruit, and 100 lemons over the course of a year, our
market basket for this example.
Table 7-3 shows the pre-frost and post-frost cost of this market basket. Before
the frost, it cost $95; after the frost, the same bundle of goods cost $175. Since
$175/$95 = 1.842, the post-frost basket costs 1.842 times the cost of the pre-frost
basket, a cost increase of 84.2%. In this example, the average price of citrus fruit
has increased 84.2% since the base year as a result of the frost, where the base
year is the initial year used in the measurement of the price change.
TABLE 7-3
Calculating the Cost of a Market Basket
Pre-frost
Post-frost
Price of orange
$0.20
$0.40
Price of grapefruit
0.60
1.00
Price of lemon
0.25
0.45
(200 × $0.20) +
(50 × $0.60) +
(100 × $0.25) = $95.00
(200 × $0.40) +
(50 × $1.00) +
(100 × $0.45) = $175.00
Cost of market basket
(200 oranges, 50 grapefruit,
100 lemons)
Economists use the same method to measure changes in the overall price
level: they track changes in the cost of buying a given market basket. In addition,
they perform another simplification in order to avoid having to keep track of the
information that the market basket cost—for example, to avoid saying that the
market basket costs $95 in 1997 dollars and $103 in 2001 dollars. They normalize
the measure of the aggregate price level, which means that they set the cost of the
market basket equal to 100 in the chosen base year. Working with a market basket
and a base year, and after performing normalization, we obtain what is known as
a price index, a normalized measure of the overall price level. It is always cited
along with the year for which the aggregate price level is being measured and the
base year. A price index can be calculated using the following formula:
(7-2) Price index in a given year =
Cost of market basket in a given year
× 100
Cost of market basket in base year
CHAPTER 7
GDP AND THE CPI: TR ACKING THE MACROECONOMY
In our example, the citrus fruit market basket cost $95 in the base year, the
year before the frost. So by Equation 7-2 we define the price index for citrus fruit
as (cost of market basket in a given year/$95) × 100, yielding an index of 100 for
the period before the frost and 184.2 after the frost. You should note that the price
index for the base year always results in a price index equal to 100. This is because
the price index in the base year is equal to: (cost of market basket in base year/
cost of market basket in base year) × 100 = 100.
Thus, the price index makes it clear that the average price of citrus has risen
84.2% as a consequence of the frost. Because of its simplicity and intuitive appeal,
the method we’ve just described is used to calculate a variety of price indexes to
track average price changes among a variety of different groups of goods and
services. For example, the consumer price index, which we’ll discuss shortly, is
the most widely used measure of the aggregate price level, the overall price level
of final consumer goods and services across the economy.
Price indexes are also the basis for measuring inflation. The inflation rate
is the annual percent change in an official price index. The inflation rate from
year 1 to year 2 is calculated using the following formula, where we assume that
year 1 and year 2 are consecutive years.
(7-3) Inflation rate =
207
The inflation rate is the percent
change per year in a price index—
typically the consumer price index.
The consumer price index, or CPI,
measures the cost of the market
basket of a typical urban American
family.
Price index in year 2 − Price index in year 1
× 100
Price index in year 1
Typically, a news report that cites “the inflation rate” is referring to the annual
percent change in the consumer price index.
The Consumer Price Index
The most widely used measure of prices in the United
States is the consumer price index (often referred to simply as the CPI), which is intended to show how the cost of
all purchases by a typical urban family has changed over
time. It is calculated by surveying market prices for a market basket that is constructed to represent the consumption
of a typical family of four living in a typical American city.
The base period for the index is currently 1982–1984; that
is, the index is calculated so that the average of consumer
prices in 1982–1984 is 100.
The market basket used to calculate the CPI is far more
complex than the three-fruit market basket we described
above. In fact, to calculate the CPI, the Bureau of Labor
Statistics sends its employees out to survey supermarkets, gas
stations, hardware stores, and so on—some 23,000 retail outlets in 87 cities. Every month it tabulates about 80,000 prices,
on everything from romaine lettuce to a medical check-up.
Figure 7-5 shows the weight of major categories in the
consumer price index as of December 2010. For example,
motor fuel, mainly gasoline, accounted for 5% of the CPI in
December 2010. So when gas prices rose nearly 150%, from
about $1.61 a gallon in late 2008 to $3.96 a gallon in May
2011, the effect was to increase the CPI by about 1.5 times
5%—that is, around 7.5%.
Figure 7-6 shows how the CPI has changed since measurement began in 1913. Since 1940, the CPI has risen
steadily, although its annual percent increases in recent
years have been much smaller than those of the 1970s and
early 1980s. (A logarithmic scale is used so that equal percent changes in the CPI have the same slope.)
FIGURE 7-5
The Makeup of the Consumer
Price Index in 2010
Other goods
Education and and services
communication
3%
6%
Recreation
Food and
6%
beverages
Medical care
15%
7%
Transportation
12%*
Housing
41%
Motor fuel
5%
Apparel
4%
*Excludes motor fuel.
This chart shows the percentage shares of major types
of spending in the CPI as of December 2010. Housing,
food, transportation, and motor fuel made up about 73%
of the CPI market basket. (Numbers don’t add to 100%
due to rounding.)
Source: Bureau of Labor Statistics.
208 P A R T 3
FIGURE 7-6
INTRODUCTION TO MACROECONOMICS
The CPI, 1913–2013
Since 1940, the CPI has risen
steadily. But the annual percentage
increases in recent years have been
much smaller than those of the
1970s and early 1980s. (The vertical
axis is measured on a logarithmic
scale so that equal percent changes
in the CPI have the same slope.)
Source: Bureau of Labor Statistics.
Log CPI
(1982 – 1984 = 100)
5.5
5.0
4.5
4.0
3.5
3.0
2.5
13
20
03
20
93
19
83
19
73
19
63
19
53
19
43
19
33
19
23
19
19
13
2.0
Year
The producer price index, or PPI,
measures changes in the prices of
goods purchased by producers.
The GDP deflator for a given year is
100 times the ratio of nominal GDP
to real GDP in that year.
The United States is not the only country that calculates a consumer price index.
In fact, nearly every country has one. As you might expect, the market baskets
that make up these indexes differ quite a lot from country to country. In poor
countries, where people must spend a high proportion of their income just to feed
themselves, food makes up a large share of the price index. Among high-income
countries, differences in consumption patterns lead to differences in the price
indexes: the Japanese price index puts a larger weight on raw fish and a smaller
weight on beef than ours does, and the French price index puts a larger weight
on wine.
Other Price Measures
There are two other price measures that are also widely used to track economywide price changes. One is the producer price index (or PPI, which used to be
known as the wholesale price index). As its name suggests, the producer price
index measures the cost of a typical basket of goods and services—containing raw
commodities such as steel, electricity, coal, and so on—purchased by producers.
Because commodity producers are relatively quick to change prices when they
perceive a change in overall demand for their goods, the PPI often responds to
inflationary or deflationary pressures more quickly than the CPI. As a result, the
PPI is often regarded as an “early warning signal” of changes in the inflation rate.
The other widely used price measure is the GDP deflator; it isn’t exactly a price
index, although it serves the same purpose. Recall how we distinguished between
nominal GDP (GDP in current prices) and real GDP (GDP calculated using the
prices of a base year). The GDP deflator for a given year is equal to 100 times the
ratio of nominal GDP for that year to real GDP for that year. Since real GDP is
currently expressed in 2005 dollars, the GDP deflator for 2005 is equal to 100. If
nominal GDP doubles but real GDP does not change, the GDP deflator indicates
that the aggregate price level doubled.
Perhaps the most important point about the different inflation rates generated by these three measures of prices is that they usually move closely together
(although the producer price index tends to fluctuate more than either of
the other two measures). Figure 7-7 shows the annual percent changes in the
three indexes since 1930. By all three measures, the U.S. economy experienced
CHAPTER 7
FIGURE 7-7
GDP AND THE CPI: TR ACKING THE MACROECONOMY
209
The CPI, the PPI, and the GDP Deflator
As the figure shows, the three
different measures of inflation, the
PPI (orange), the CPI (green), and
the GDP deflator (purple), usually
move closely together. Each reveals
a drastic acceleration of inflation
during the 1970s and a return to
relative price stability in the 1990s.
With the exception of a brief period
of deflation in 2009, prices have
remained stable from 2000 to 2013.
Percent change in
the CPI, PPI, GDP
deflator
Sources: Bureau of Labor Statistics; Bureau
of Economic Analysis.
PPI
25%
20
15
CPI
10
5
0
–5
GDP
deflator
–10
–15
20
1
20 0
13
00
20
90
19
80
19
70
19
60
19
50
19
40
19
19
30
–20
Year
deflation during the early years of the Great Depression, inflation during World
War II, accelerating inflation during the 1970s, and a return to relative price stability in the 1990s. Notice, by the way, the dramatic ups and downs in producer
prices from 2000 to 2013 on the graph; this reflects large swings in energy and
food prices, which play a much bigger role in the PPI than they do in either the
CPI or the GDP deflator.
s
ECONOMICS
in Action
Indexing to the CPI
A
policy, official statistics on GDP don’t have a direct effect on people’s
lives. The CPI, by contrast, has a direct and immediate impact on
millions of Americans.
The reason is that many payments are tied, or “indexed,” to the
CPI—the amount paid rises or falls when the CPI rises or falls.
The practice of indexing payments to consumer prices goes back to
the dawn of the United States as a nation. In 1780 the Massachusetts
State Legislature recognized that the pay of its soldiers fighting the
British needed to be increased because of inflation that occurred
during the Revolutionary War. The legislature adopted a formula that made a soldier’s pay proportional to the cost of a market
basket, consisting of 5 bushels of corn, 68 4/7 pounds of beef, 10 pounds of
sheep’s wool, and 16 pounds of shoe leather.
Today, 54 million people receive payments from Social Security, a
national retirement program that accounts for almost a quarter of current total federal spending—more than the defense budget. The amount
of an individual’s Social Security payment is determined by a formula
that reflects his or her previous payments into the system as well as other
factors. In addition, all Social Security payments are adjusted each year
to offset any increase in consumer prices over the previous year. The
CPI is used to calculate the official estimate of the inflation rate used to
Library of Congress Prints and Photographs Division [LC-DIG-ppmsca-07216]
lthough GDP is a very important number for shaping economic
A small change in the CPI has large
consequences for those dependent on
Social Security payments.
210 P A R T 3
INTRODUCTION TO MACROECONOMICS
Quick Review
• Changes in the aggregate price
level are measured by the cost
of buying a particular market
basket during different years. A
price index for a given year is the
cost of the market basket in that
year normalized so that the price
index equals 100 in a selected base
year.
• The inflation rate is calculated
as the percent change in a price
index. The most commonly used
price index is the consumer price
index, or CPI, which tracks the
cost of a basket of consumer
goods and services. The producer
price index, or PPI, does the
same for goods and services used
as inputs by firms. The GDP
deflator measures the aggregate
price level as the ratio of nominal
to real GDP times 100. These
three measures normally behave
quite similarly.
adjust these payments yearly. So every percentage point added to the official
estimate of the rate of inflation adds 1% to the checks received by tens of millions of individuals.
Other government payments are also indexed to the CPI. In addition, income
tax brackets, the bands of income levels that determine a taxpayer’s income tax
rate, are also indexed to the CPI. (An individual in a higher income bracket pays
a higher income tax rate in a progressive tax system like ours.) Indexing also
extends to the private sector, where many private contracts, including some wage
settlements, contain cost-of-living allowances (called COLAs) that adjust payments in proportion to changes in the CPI.
Because the CPI plays such an important and direct role in people’s lives, it’s
a politically sensitive number. The Bureau of Labor Statistics, which calculates
the CPI, takes great care in collecting and interpreting price and consumption
data. It uses a complex method in which households are surveyed to determine
what they buy and where they shop, and a carefully selected sample of stores are
surveyed to get representative prices.
Check Your Understanding
7-3
1.Consider Table 7-3 but suppose that the market basket is composed of 100 oranges,
50 grapefruit, and 200 lemons. How does this change the pre-frost and post-frost
price indexes? Explain. Generalize your explanation to how the construction of the
market basket affects the price index.
2.For each of the following events, how would an economist using a 10-year-old
market basket create a bias in measuring the change in the cost of living today?
a. A typical family owns more cars than it would have a decade ago. Over that
time, the average price of a car has increased more than the average prices of
other goods.
b. Virtually no households had broadband internet access a decade ago. Now
many households have it, and the price has regularly fallen each year.
The consumer price index in the United States (base period 1982–1984) was
3.
226.229 in 2012 and 229.324 in 2013. Calculate the inflation rate from 2012 to 2013.
Solutions appear at back of book.
CASE
Getting a Jump on GDP
G
DP matters. Investors and business leaders are always anxious to get the
latest numbers. When the Bureau of Economic Analysis releases its first
estimate of each quarter’s GDP, normally on the 27th or 28th day of the
month after the quarter ends, it’s invariably a big news story.
In fact, many companies and other players in the economy are so eager to
know what’s happening to GDP that they don’t want to wait for the official estimate. So a number of organizations produce numbers that can
be used to predict what the official GDP number will say. Let’s
talk about two of those organizations, the economic consulting firm Macroeconomic Advisers and the nonprofit Institute
of Supply Management.
Macroeconomic Advisers takes a direct approach: it
produces its own estimates of GDP based on raw data
from the U.S. government. But whereas the Bureau of
Economic Analysis estimates GDP only on a quarterly basis,
Macroeconomic Advisers produces monthly estimates. This
means that clients can, for example, look at the estimates for
January and February and make a pretty good guess at what
first-quarter GDP, which also includes March, will turn out to
be. The monthly estimates are derived by looking at a number
of monthly measures that track purchases, such as car and
truck sales, new housing construction, and exports.
The Institute for Supply Management (ISM) takes a very
different approach. It relies on monthly surveys of purchasing
managers—that is, executives in charge of buying supplies—
who are basically asked whether their companies are increasing or reducing
production. (We say “basically” because the ISM asks a longer list of questions.)
Responses to the surveys are released in the form of indexes showing the percentage of companies that are expanding. Obviously, these indexes don’t directly
tell you what is happening to GDP. But historically, the ISM indexes have been
strongly correlated with the rate of growth of GDP, and this historical relationship can be used to translate ISM data into “early warning” GDP estimates.
So if you just can’t wait for those quarterly GDP numbers, you’re not alone.
The private sector has responded to demand, and you can get your data fix every
month.
Monkey Business Images/Shutterstock
BUSINESS
QUESTIONS FOR THOUGHT
1. Why do businesses care about GDP to such an extent that they want early
estimates?
2. How do the methods of Macroeconomic Advisers and the Institute for Supply
Management fit into the three different ways to calculate GDP?
3. If private firms are producing GDP estimates, why do we need the Bureau of
Economic Analysis?
211
212 P A R T 3
INTRODUCTION TO MACROECONOMICS
SUMMARY
1. Economists keep track of the flows of money between
sectors with the national income and product
accounts, or national accounts. Households earn
income via the factor markets from wages, interest on
bonds, profit accruing to owners of stocks, and rent
on land and structures. In addition, they receive government transfers from the government. Disposable
income, total household income minus taxes plus government transfers, is allocated to consumer spending
(C) and private savings. Via the financial markets,
private savings and foreign lending are channeled to
investment spending (I), government borrowing, and
foreign borrowing. Government purchases of goods
and services (G) are paid for by tax revenues and any
government borrowing. Exports (X) generate an
inflow of funds into the country from the rest of the
world, but imports (IM) lead to an outflow of funds to
the rest of the world. Foreigners can also buy stocks
and bonds in the U.S. financial markets.
2. Gross domestic product, or GDP, measures the
value of all final goods and services produced in the
economy. It does not include the value of intermediate
goods and services, but it does include inventories
and net exports (X − IM). It can be calculated in three
ways: add up the value added by all producers; add
up all spending on domestically produced final goods
and services, leading to the equation GDP = C + I + G
+ X − IM, also known as aggregate spending; or add
up all the income paid by domestic firms to factors
of production. These three methods are equivalent
because in the economy as a whole, total income paid
by domestic firms to factors of production must equal
total spending on domestically produced final goods
and services.
3. Real GDP is the value of the final goods and services
produced calculated using the prices of a selected base
year. Except in the base year, real GDP is not the same
as nominal GDP, the value of aggregate output calculated using current prices. Analysis of the growth rate
of aggregate output must use real GDP because doing
so eliminates any change in the value of aggregate output due solely to price changes. Real GDP per capita
is a measure of average aggregate output per person
but is not in itself an appropriate policy goal. U.S. statistics on real GDP are always expressed in chained
dollars.
4. To measure the aggregate price level, economists cal-
culate the cost of purchasing a market basket. A price
index is the ratio of the current cost of that market
basket to the cost in a selected base year, multiplied by
100.
5. The inflation rate is the yearly percent change in a
price index, typically based on the consumer price
index, or CPI, the most common measure of the
aggregate price level. A similar index for goods and services purchased by firms is the producer price index,
or PPI. Finally, economists also use the GDP deflator,
which measures the price level by calculating the ratio
of nominal GDP to real GDP times 100.
KEY TERMS
National income and product accounts
(national accounts), p. 192
Consumer spending, p. 192
Stock, p. 192
Bond, p. 192
Government transfers, p. 192
Disposable income, p. 192
Private savings, p. 193
Financial markets, p. 193
Government borrowing, p. 194
Government purchases of goods and
services, p. 194
Exports, p. 194
Imports, p. 194
Inventories, p. 194
Investment spending, p. 194
Final goods and services, p. 195
Intermediate goods and services, p. 195
Gross domestic product (GDP), p. 195
Aggregate spending, p. 195
Value added, p. 197
Net exports, p. 200
Aggregate output, p. 202
Real GDP, p. 202
Nominal GDP, p. 203
Chained dollars, p. 203
GDP per capita, p. 203
Aggregate price level, p. 206
Market basket, p. 206
Price index, p. 206
Inflation rate, p. 207
Consumer price index (CPI), p. 207
Producer price index (PPI), p. 208
GDP deflator, p. 208
CHAPTER 7
GDP AND THE CPI: TR ACKING THE MACROECONOMY
213
PROBLEMS
1. At right is a simplified circular-flow diagram for
Government purchases of
goods and services = $100
the economy of Micronia. (Note that there is no
investment in Micronia.)
a. What is the value of GDP in Micronia?
Government
Taxes = $100
b. What is the value of net exports?
c. What is the value of disposable income?
d. Does the total flow of money out of house-
Consumer
spending = $650
holds—the sum of taxes paid and consumer
spending—equal the total flow of money into
households?
Households
Wages, profit,
interest,
rent = $750
Factor
markets
Markets for goods
and services
e. How does the government of Micronia finance
its purchases of goods and services?
Gross
domestic
product
Wages, profit,
interest,
rent = $750
Firms
Exports = $20
Imports = $20
2. A more complex circular-
flow diagram for the economy of Macronia is shown at
right. (Note that Macronia
has investment and financial
markets.)
a. What is the value of GDP
in Macronia?
b. What is the value of net
Government purchases of
goods and services = $150
Rest of world
Government borrowing = $60
Government
Taxes = $100
Consumer
spending = $510
Government transfers = $10
Private savings = $200
Wages, profit,
interest,
rent = $800
Households
exports?
c. What is the value of dis-
posable income?
d. Does the total flow of
money out of households—
the sum of taxes paid,
consumer spending, and
private savings—equal the
total flow of money into
households?
e. How does the government
Factor
markets
Markets for goods
and services
Gross
domestic
product
Wages, profit,
interest,
rent = $800
Investment
spending = $110
Imports = $20
Borrowing and
stock issues by
firms = $110
Firms
Exports = $50
finance its spending?
Financial
markets
Rest of world
Foreign borrowing
and sales of stock = $130
Foreign lending and
purchases of stock = $100
214 P A R T 3
INTRODUCTION TO MACROECONOMICS
3. The components of GDP in the accompanying table
were produced by the Bureau of Economic Analysis.
Category
Components of GDP in 2013
(billions of dollars)
The accompanying table summarizes the activities of
the three companies when all the bread and cheese
produced are sold to the pizza company as inputs in the
production of pizzas.
Consumer spending
Durable goods
$1,263.0
Nondurable goods
2,622.9
Services
7,615.7
Private investment spending
Fixed investment spending
2,564.0
Nonresidential
2,047.1
Structures
456.4
Equipment and intellectual
property products
1,590.7
Residential
516.9
Change in private inventories
106.1
Net exports
Exports
2,259.9
Imports
2,757.2
Government purchases of
goods and services and
investment spending
Federal
1,245.9
National defense
770.7
Nondefense
475.1
State and local
1,879.6
a. Calculate 2013 consumer spending.
b. Calculate 2013 private investment spending.
c. Calculate 2013 net exports.
d. Calculate 2013 government purchases of goods and
Cost of inputs
Bread
company
Cheese
company
$0
$0
Pizza
company
$50 (bread)
35 (cheese)
Wages
15
20
75
Value of output
50
35
200
a. Calculate GDP as the value added in production.
b. Calculate GDP as spending on final goods and
­services.
c. Calculate GDP as factor income.
5. In the economy of Pizzania (from Problem 4), bread and
cheese produced are sold both to the pizza company for
inputs in the production of pizzas and to consumers as
final goods. The accompanying table summarizes the
activities of the three companies.
Bread
company
Cheese
company
Pizza
company
Cost of inputs
$0
$0
$50 (bread)
Wages
25
30
75
Value of output
100
60
200
35 (cheese)
a. Calculate GDP as the value added in production.
b. Calculate GDP as spending on final goods and
­services.
c. Calculate GDP as factor income.
6. Which of the following transactions will be included in
e. Calculate 2013 gross domestic product.
GDP for the United States?
a. Coca­- ­Cola builds a new bottling plant in the United
States.
f. Calculate 2013 consumer spending on services as a
b. Delta sells one of its existing airplanes to Korean
services and government investment spending.
percentage of total consumer spending.
g. Calculate 2013 exports as a percentage of imports.
h. Calculate 2013 government purchases on national
defense as a percentage of federal government purchases of goods and services.
4. The small economy of Pizzania produces three goods
(bread, cheese, and pizza), each produced by a separate
company. The bread and cheese companies produce all
the inputs they need to make bread and cheese, respectively. The pizza company uses the bread and cheese
from the other companies to make its pizzas. All three
companies employ labor to help produce their goods,
and the difference between the value of goods sold and
the sum of labor and input costs is the firm’s profit.
Air.
c. Ms. Moneybags buys an existing share of Disney
stock.
d. A California winery produces a bottle of
Chardonnay and sells it to a customer in Montreal,
Canada.
e. An American buys a bottle of French perfume in
Tulsa.
f. A book publisher produces too many copies of a new
book; the books don’t sell this year, so the publisher
adds the surplus books to inventories.
7. The accompanying table shows data on nominal GDP
(in billions of dollars), real GDP (in billions of 2005 dol-
CHAPTER 7
GDP AND THE CPI: TR ACKING THE MACROECONOMY
lars), and population (in thousands) of the United States
in 1960, 1970, 1980, 1990, 2000, and 2010. The U.S. price
level rose consistently over the period 1960–2010.
Year
Nominal GDP
(billions of
dollars)
Real GDP
(billions of
2005 dollars)
Population
(thousands)
1960
$526.4
$2,828.5
180,760
1970
1,038.5
4,266.3
205,089
1980
2,788.1
5,834.0
227,726
1990
5,800.5
8,027.1
250,181
2000
9,951.5
11,216.4
282,418
2010
14,526.5
13,088.0
310,106
a. Why is real GDP greater than nominal GDP for all
years until 2000 and lower for 2010?
b. Calculate the percent change in real GDP from 1960
9. The consumer price index, or CPI, measures the cost of
living for a typical urban household by multiplying the
price for each category of expenditure (housing, food,
and so on) times a measure of the importance of that
expenditure in the average consumer’s market basket
and summing over all categories. However, using data
from the consumer price index, we can see that changes
in the cost of living for different types of consumers can
vary a great deal. Let’s compare the cost of living for a
hypothetical retired person and a hypothetical college
student. Let’s assume that the market basket of a retired
person is allocated in the following way: 10% on housing, 15% on food, 5% on transportation, 60% on medical care, 0% on education, and 10% on recreation. The
college student’s market basket is allocated as follows:
5% on housing, 15% on food, 20% on transportation,
0% on medical care, 40% on education, and 20% on
recreation. The accompanying table shows the March
2014 CPI for each of the relevant categories.
to 1970, 1970 to 1980, 1980 to 1990, 1990 to 2000,
and 2000 to 2010. Which period had the highest
growth rate?
c. Calculate real GDP per capita for each of the years
in the table.
d. Calculate the percent change in real GDP per capita
from 1960 to 1970, 1970 to 1980, 1980 to 1990, 1990
to 2000, and 2000 to 2010. Which period had the
highest growth rate?
e. How do the percent change in real GDP and the
percent change in real GDP per capita compare?
Which is larger? Do we expect them to have this
­relationship?
8. Eastland College is concerned about the rising price
of textbooks that students must purchase. To better
identify the increase in the price of textbooks, the dean
asks you, the Economics Department’s star student, to
create an index of textbook prices. The average student
purchases three English, two math, and four economics
textbooks per year. The prices of these books are given
in the accompanying table.
2012
2013
2014
English textbook
$100
$110
$114
Math textbook
140
144
148
Economics textbook
160
180
200
a. What is the percent change in the price of an
English textbook from 2012 to 2014?
b. What is the percent change in the price of a math
textbook from 2012 to 2014?
c. What is the percent change in the price of an eco-
nomics textbook from 2012 to 2014?
d. Using 2013 as a base year, create a price index for
these books for all years.
e. What is the percent change in the price index from
2012 to 2014?
215
CPI
March 2014
Housing
228.7
Food
239.7
Transportation
219.3
Medical care
436.5
Education
229.1
Recreation
115.7
Calculate the overall CPI for the retired person and for
the college student by multiplying the CPI for each of
the categories by the relative importance of that category to the individual and then summing each of the
categories. The CPI for all items in March 2014 was
235.6. How do your calculations for a CPI for the retired
person and the college student compare to the overall
CPI?
10. Go to the Bureau of Labor Statistics home page at www.
bls.gov. Place the cursor over the “Economic Releases”
tab and then click on “Major Economic Indicators”
in the drop-down menu that appears. Once on the
“Major Economic Indicators” page, click on “Consumer
Price Index.” On that page, under “Table of Contents,”
click on “Table 1: Consumer Price Index for All Urban
Consumers.” Using the “unadjusted” figures, determine
what the CPI was for the previous month. How did it
change from the previous month? How does the CPI
compare to the same month one year ago?
216 P A R T 3
INTRODUCTION TO MACROECONOMICS
11. The accompanying table provides the annual real GDP
(in billions of 2009 dollars) and nominal GDP (in billions of dollars) for the United States.
2009
Real
GDP
(billions
of 2009
dollars)
Nominal
GDP
(billions
of
dollars)
2010
2011
2012
2013
14,417.9 14,779.4 15,052.4 15,470.7 15,761.3
WORK IT OUT
For interactive, step-by-step help in solving the following problem,
by using the URL on the back cover of this book.
visit
14. The economy of Britannica produces three goods:
computers, DVDs, and pizza. The accompanying
table shows the prices and output of the three goods
for the years 2012, 2013, and 2014.
Computers
14,417.9 14,958.3 15,533.8 16,244.6 16,799.7
a. Calculate the GDP deflator for each year.
b. Use the GDP deflator to calculate the inflation rate
Year
Price
2012
$900
the years 2011, 2012, and 2013: the GDP deflator and the
CPI. For each price index, calculate the inflation rate
from 2011 to 2012 and from 2012 to 2013.
DVDs
Pizzas
Price
Quantity
Price
Quantity
10
$10
100
$15
2
2013 1,000
10.5
12
105
16
2
2014 1,050
12
14
110
17
3
a. What is the percent change in production of each
of the goods from 2012 to 2013 and from 2013 to
2014?
for all years except 2009.
12. The accompanying table contains two price indexes for
Quantity
b. What is the percent change in prices of each of
the goods from 2012 to 2013 and from 2013 to
2014?
c. Calculate nominal GDP in Britannica for each
Year
GDP deflator
CPI
2011
103.199
224.939
2012
105.002
229.594
2013
106.588
232.957
of the three years. What is the percent change
in nominal GDP from 2012 to 2013 and from
2013 to 2014?
d. Calculate real GDP in Britannica using 2012
prices for each of the three years. What is the
percent change in real GDP from 2012 to 2013
and from 2013 to 2014?
13. The cost of a college education in the United States
is rising at a rate faster than inflation. The following
table shows the average cost of a college education in
the United States during the academic year that began
in 2011 and the academic year that began in 2012 for
public and private colleges. Assume the costs listed in
the table are the only costs experienced by the various
college students in a single year.
a. Calculate the cost of living for an average college
student in each category for 2011 and 2012.
b. Calculate an inflation rate for each type of college
student between 2011 and 2012.
Cost of college education during academic year beginning
2011 (averages in 2011 dollars)
Tuition
and fees
Room
and board
Books
and ­supplies
Other
expenses
Two-year public college: commuter
$2,970
$5,552
$1,314
$2,988
Four-year public college: in-state, on-campus
7,731
8,831
1,232
3,203
Four-year public college: out-of-state, on-campus
20,823
8,831
1,232
3,203
Four-year private college: on-campus
27,949
9,853
1,238
2,378
Cost of college education during academic year beginning
2012 (averages in 2012 dollars)
Tuition
and fees
Room
and board
Books
and ­supplies
Other
expenses
Two-year public college: commuter
$3,080
$5,817
$1,341
$3,040
Four-year public college: in-state, on-campus
8,805
9,183
1,243
3,253
Four-year public college: out-of-state, on-campus
21,706
9,183
1,243
3,253
Four-year private college: on-campus
29,115
10,181
1,243
2,423
CHAPTER
Unemployment and
Inflation
8
HITTING THE BRAKING POINT
s
What You Will Learn
in This Chapter
How unemployment is
•measured
and how the
unemployment rate is calculated
The significance of the
•unemployment
rate for the
economy
The relationship between the
•unemployment
rate and economic
The factors that determine the
•natural
rate of unemployment
• The economic costs of inflation
How inflation and deflation
•create
winners and losers
Why policy makers try to
•maintain
a stable rate of inflation
Bradley Boner/Bloomberg via Getty Images
growth
As chair of the Federal Reserve, Janet Yellen balances the goals of low unemployment and
price stability when deciding whether to give the economy more gas or hit the brakes.
E
very August many of the world’s
most powerful financial officials
and many influential economists
gather in Jackson Hole, Wyoming, for
a conference sponsored by the Federal
Reserve Bank of Kansas City. Financial
journalists come too, hoping to get clues
about the future direction of policy. It’s
always an interesting scene—but in
August 2014 it was even more interesting than usual.
What was different about that year’s
conclave? One answer was that the
Federal Reserve’s Board of Governors,
which makes U.S. monetary policy, had a
new chair—and Janet Yellen had already
made history as the first woman to hold
the position.
Beyond the historic first, however,
there was a widespread sense that
August that U.S. monetary policy might
be approaching a critical moment. For
almost six years the Fed’s goal had
been simple, if hard to accomplish: boost
the U.S. economy out of a sustained
job drought that had kept unemployment
high. By the summer of 2014, however, the
unemployment rate had fallen much of
the way back toward historically normal
levels. At some point, almost everyone
agreed, it would be time for the Fed to
take its foot off the gas and hit the brakes
instead, raising interest rates that had
been close to zero for years. But when?
It was a fraught question. Some Fed
officials—so-called hawks, always ready
to pounce on any sign of inflation—
warned that if the Fed waited too long
to raise rates, inflation would shoot up to
unacceptable levels. Others—so-called
doves—warned that the economy was
still fragile, and that raising rates too soon
would risk condemning the economy to
a further stretch of high unemployment.
Ms. Yellen was, in general, part of the
dovish camp. But even she warned that
controlling inflation must eventually
take priority over reducing unemployment. At that point the Fed would have
to raise rates.
Only time would tell who was
right about the timing. But the dispute highlighted the key concerns of
macroeconomic policy. Unemployment
and inflation are the two great evils of
macroeconomics. So the two principal
goals of macroeconomic policy are low
unemployment and price stability, usually defined as a low but positive rate
of inflation. Unfortunately, these goals
sometimes seem to be in conflict with
each other: economists often warn that
policies intended to reduce unemployment run the risk of increasing inflation;
conversely, policies intended to bring
down inflation can raise unemployment.
We’ll learn much more about the
nature of the trade-off between low
unemployment and low inflation and the
policy dilemma it creates in later chapters. This chapter provides an overview
of the basic facts about unemployment
and inflation: how they’re measured,
how they affect consumers and firms,
and how they change over time.
217
218
PA R T 3
INTRODUCTION TO MACROECONOMICS
Employment is the number of
people currently employed in the
economy, either full time or part time.
Unemployment is the number of
people who are actively looking for
work but aren’t currently employed.
The Unemployment Rate
The U.S. unemployment rate in October 2014 was 5.8%. That was a substantial
improvement from the situation a few years earlier. In late 2009, after the Great
Recession, unemployment peaked at 10%. But unemployment was still well above
pre-recession levels; it was only 4.7% in November 2007.
Figure 8-1 shows the U.S. unemployment rate from 1948 to late 2014; as you
can see, unemployment soared during the Great Recession of 2007–2009 and
fell only slowly in the years that followed. What did the elevated unemployment
rate mean, and why was it such a big factor in people’s lives? To understand why
policy makers pay so much attention to employment and unemployment, we need
to understand how they are both defined and measured.
Defining and Measuring Unemployment
It’s easy to define employment: you’re employed if and only if you have a job.
Employment is the total number of people currently employed, either full time
or part time.
Unemployment, however, is a more subtle concept. Just because a person isn’t
working doesn’t mean that we consider that person unemployed. For example,
as of October 2014, there were 41.8 million retired workers in the United States
receiving Social Security checks. Most of them were probably happy that they
were no longer working, so we wouldn’t consider someone who has settled into a
comfortable, well-earned retirement to be unemployed. There were also 11 million disabled U.S. workers receiving benefits because they were unable to work.
Again, although they weren’t working, we wouldn’t normally consider them to be
unemployed.
The U.S. Census Bureau, the federal agency tasked with collecting data on
unemployment, considers the unemployed to be those who are “jobless, looking
for jobs, and available for work.” Retired people don’t count because they aren’t
looking for jobs; the disabled don’t count because they aren’t available for work.
More specifically, an individual is considered unemployed if he or she doesn’t currently have a job and has been actively seeking a job during the past four weeks.
So unemployment is defined as the total number of people who are actively looking for work but aren’t currently employed.
The U.S. Unemployment Rate, 1948–2014
10
8
6
4
10
20
14
20
20
00
0
19
9
80
19
70
19
60
2
19
Sources: Bureau of Labor Statistics;
National Bureau of Economic Research.
Unemployment
rate
12%
48
The unemployment rate has
fluctuated widely over time. It always
rises during recessions, which are
shown by the shaded bars. It usually,
but not always, falls during periods
of economic expansion.
19
FIGURE 8-1
Year
CHAPTER 8
U N E M P L O Y M E N T A N D I N F L AT I O N
A country’s labor force is the sum of employment and unemployment—that
is, of people who are currently working and people who are currently looking for
work, respectively. The labor force participation rate, defined as the percentage
of the working-age population that is in the labor force, is calculated as follows:
(8-1) Labor force participation rate =
Labor force
× 100
Population age 16 and older
The unemployment rate, defined as the percentage of the total number of
people in the labor force who are unemployed, is calculated as follows:
(8-2) Unemployment rate =
Number of unemployed workers
× 100
Labor force
To estimate the numbers that go into calculating the unemployment rate, the
U.S. Census Bureau carries out a monthly survey called the Current Population
Survey, which involves interviewing a random sample of 60,000 American
families. People are asked whether they are currently employed. If they are not
employed, they are asked whether they have been looking for a job during the past
four weeks. The results are then scaled up, using estimates of the total population, to estimate the total number of employed and unemployed Americans.
The Significance of the Unemployment Rate
In general, the unemployment rate is a good indicator of how easy or difficult it is
to find a job given the current state of the economy. When the unemployment rate
is low, nearly everyone who wants a job can find one. In 2000, when the unemployment rate averaged just 4%, jobs were so abundant that employers spoke of a
“mirror test” for getting a job: if you were breathing (therefore your breath would
fog a mirror), you could find work. By contrast, in 2010, with the unemployment
rate above 9% all year, it was very hard to find work. In fact, there were almost
five times as many Americans seeking work as there were job openings.
Although the unemployment rate is a good indicator of current labor market
conditions, it’s not a literal measure of the percentage of people who want a job
but can’t find one. That’s because in some ways the unemployment rate exaggerates the difficulty people have in finding jobs. But in other ways, the opposite is
true—a low unemployment rate can conceal deep frustration over the lack of job
opportunities.
How the Unemployment Rate Can Overstate the True Level of
Unemployment If you are searching for work, it’s normal to take at least a few
weeks to find a suitable job. Yet a worker who is quite confident of finding a job,
but has not yet accepted a position, is counted as unemployed. As a consequence,
the unemployment rate never falls to zero, even in boom times when jobs are
plentiful. Even in the buoyant labor market of 2000, when it was easy to find
work, the unemployment rate was still 4%. Later in this chapter, we’ll discuss in
greater depth the reasons that measured unemployment persists even when jobs
are abundant.
How the Unemployment Rate Can Understate the True Level of
Unemployment Frequently, people who would like to work but aren’t working
still don’t get counted as unemployed. In particular, an individual who has given
up looking for a job for the time being because there are no jobs available—say,
a laid-off steelworker in a deeply depressed steel town—isn’t counted as unemployed because he or she has not been searching for a job during the previous
four weeks. Individuals who want to work but have told government researchers
that they aren’t currently searching because they see little prospect of finding a
219
The labor force is equal to the sum
of employment and unemployment.
The labor force participation rate
is the percentage of the population
aged 16 or older that is in the labor
force.
The unemployment rate is the
percentage of the total number of
people in the labor force who are
unemployed.
INTRODUCTION TO MACROECONOMICS
Discouraged workers are
nonworking people who are capable
of working but have given up looking
for a job given the state of the job
market.
Marginally attached workers
would like to be employed and have
looked for a job in the recent past
but are not currently looking for
work.
Underemployment is the number
of people who work part time
because they cannot find full-time
jobs.
Alternative Measures of Unemployment, 1994–2014
Percentage of
labor force
20%
4. ... plus involuntary
part-time workers
3. ... plus marginally
attached workers
2. ... plus
discouraged
workers
15
10
5
Source: Bureau of Labor Statistics.
4
2
20
1
0
20
1
20
1
8
20
0
20
06
20
04
20
02
20
00
98
4
1. Unemployment rate ...
6
The unemployment number usually
quoted in the news media counts
someone as unemployed only if he
or she has been looking for work
during the past four weeks. Broader
measures also count discouraged
workers, marginally attached
workers, and the underemployed.
These broader measures show a
higher unemployment rate, but they
move closely in parallel with the
standard rate.
19
FIGURE 8-2
job given the state of the job market are called discouraged workers. Because
it does not count discouraged workers, the measured unemployment rate may
understate the percentage of people who want to work but are unable to find jobs.
Discouraged workers are part of a larger group—marginally attached workers. These are people who say they would like to have a job and have looked for
work in the recent past but are not currently looking for work. They, too, are not
included when calculating the unemployment rate. Finally, another category of
workers who are frustrated in their ability to find work but aren’t counted as
unemployed are the underemployed: workers who would like to find full-time
jobs but are currently working part time “for economic reasons”—that is, they
can’t find a full-time job. Again, they aren’t counted in the unemployment rate.
The Bureau of Labor Statistics is the federal agency that calculates the official
unemployment rate. It also calculates broader “measures of labor underutilization”
that include the three categories of frustrated workers. Figure 8-2 shows what
happens to the measured unemployment rate once discouraged workers, other
marginally attached workers, and the underemployed are counted. The broadest
measure of unemployment and underemployment, known as U-6, is the sum of
these three measures plus the unemployed. It is substantially higher than the rate
usually quoted by the news media. But U-6 and the unemployment rate move very
much in parallel, so changes in the unemployment rate remain a good guide to
what’s happening in the overall labor market, including frustrated workers.
Finally, it’s important to realize that the unemployment rate varies greatly
among demographic groups. Other things equal, jobs are generally easier to find
for more experienced workers and for workers during their “prime” working
years, from ages 25 to 54. For younger workers, as well as workers nearing retirement age, jobs are typically harder to find, other things equal.
Figure 8-3 shows unemployment rates for different groups in 2007, when the
overall unemployment rate was low by historical standards, in 2010, when the rate
was high in the aftermath of the Great Recession, and in 2014, when it had come
down much of, but not all, the way to pre-crisis levels. As you can see, the unemployment rate for African-American workers is consistently much higher than
the national average; the unemployment rate for White teenagers (ages 16–19) is
normally even higher; and the unemployment rate for African-American teenagers is higher still. (Bear in mind that a teenager isn’t considered unemployed, even
19
9
PA R T 3
19
9
220
Year
CHAPTER 8
FIGURE 8-3
Unemployment Rates of Different Groups in 2007, 2010, and 2014
Unemployment rates vary greatly among
different demographic groups. For example,
although the overall unemployment rate in
October 2014 was 5.8%, the unemployment
rate among African-American teenagers
was 28.1%. As a result, even during periods
of low overall unemployment, unemployment
remains a serious problem for some groups.
Unemployment
rate
2007
2010
50%
2014
44.5%
40
32.8%
30
Source: Bureau of Labor Statistics.
TK
20
10
0
9.4%
5.0%
5.8%
28.1%
22.9%
15.6%
14.4%
10.6%
9.0%
Overall
AfricanAmerican
15.6%
AfricanAmerican
teenager
White
teenager
if he or she isn’t working, unless that teenager is looking for work but can’t find
it.) So even at times when the overall unemployment rate is relatively low, jobs are
hard to find for some groups.
So you should interpret the unemployment rate as an indicator of overall labor
market conditions, not as an exact, literal measure of the percentage of people
unable to find jobs. The unemployment rate is, however, a very good indicator: its
ups and downs closely reflect economic changes that have a significant impact on
people’s lives. Let’s turn now to the causes of these fluctuations.
Growth and Unemployment
Compared to Figure 8-1, Figure 8-4 shows the U.S. unemployment rate over a
somewhat shorter period, the 35 years from 1979 through late 2014. The shaded
bars represent periods of recession. As you can see, during every recession,
Unemployment and Recessions, 1979–2014
12%
10
8
6
4
14
20
20
09
04
20
99
19
94
19
89
2
19
Sources: Bureau of Labor Statistics;
National Bureau of Economic Research.
Unemployment
rate
19
84
This figure shows a close-up of
the unemployment rate for the past
three decades, with the shaded
bars indicating recessions. It’s clear
that unemployment always rises
during recessions and usually falls
during expansions. But in both the
early 1990s and the early 2000s,
unemployment continued to rise for
some time after the recession was
officially declared over.
19
79
FIGURE 8-4
221
U N E M P L O Y M E N T A N D I N F L AT I O N
Year
222
PA R T 3
INTRODUCTION TO MACROECONOMICS
without exception, the unemployment rate rose. The severe recession of 2007–2009,
like the earlier one of 1981–1982, led to a huge rise in unemployment.
Correspondingly, during periods of economic expansion the unemployment
rate usually falls. The long economic expansion of the 1990s eventually brought
the unemployment rate to 4.0%, and the expansion of the mid-2000s brought
the rate down to 4.7%. However, it’s important to recognize that economic
expansions aren’t always periods of falling unemployment. Look at the periods
immediately following the recessions of 1990–1991 and 2001 in Figure 8-4. In
each case the unemployment rate continued to rise for more than a year after
the recession was officially over. The explanation in both cases is that although
the economy was growing, it was not growing fast enough to reduce the unemployment rate.
Figure 8-5 is a scatter diagram showing U.S. data for the period from 1949 to
2013. The horizontal axis measures the annual rate of growth in real GDP—the
percent by which each year’s real GDP changed compared to the previous year’s
real GDP. (Notice that there were ten years in which growth was negative—that
is, real GDP shrank.) The vertical axis measures the change in the unemployment
rate over the previous year in percentage points—last year’s unemployment rate
minus this year’s unemployment rate. Each dot represents the observed growth
rate of real GDP and change in the unemployment rate for a given year. For
example, in 2000 the average unemployment rate fell to 4.0% from 4.2% in 1999;
this is shown as a value of −0.2 along the vertical axis for the year 2000. Over the
same period, real GDP grew by 3.7%; this is the value shown along the horizontal
axis for the year 2000.
Growth and Changes in Unemployment, 1949–2013
FIGURE 8-5
Change in
unemployment
rate (percentage
points)
4
2010
3
2
1970
1980
2000
1
0
1990
−1
1960
−2
−3
−4
−2
2
0
1950
3.25 4
Average growth rate, 1949–2013
Each dot shows the growth rate of the economy
and the change in the unemployment rate for
a specific year between 1949 and 2013. For
example, in 2000 the economy grew 3.7% and
the unemployment rate fell 0.2 percentage points,
from 4.2% to 4.0%. In general, the unemployment
6
8
10%
Real GDP growth rate
rate fell when growth was above its average
rate of 3.25% a year and rose when growth was
below average. Unemployment always rose when
real GDP fell.
Sources: Bureau of Labor Statistics; Bureau of Economic
Analysis.
CHAPTER 8
U N E M P L O Y M E N T A N D I N F L AT I O N
The downward trend of the scatter diagram in Figure 8-5 shows that there is
a generally strong negative relationship between growth in the economy and the
rate of unemployment. Years of high growth in real GDP were also years in which
the unemployment rate fell, and years of low or negative growth in real GDP were
years in which the unemployment rate rose.
The green vertical line in Figure 8-5 at the value of 3.25% indicates the average growth rate of real GDP over the period from 1949 to 2013. Points lying to
the right of the vertical line are years of above-average growth. In these years,
the value on the vertical axis is usually negative, meaning that the unemployment
rate fell. That is, years of above-average growth were usually years in which the
unemployment rate was falling. Conversely, points lying to the left of the green
vertical line were years of below-average growth. In these years, the value on the
vertical axis is usually positive, meaning that the unemployment rate rose. That
is, years of below-average growth were usually years in which the unemployment
rate was rising.
A period in which real GDP is growing at a below-average rate and unemployment is rising is called a jobless recovery or a “growth recession.” Since 1990,
there have been three recessions, each of which was followed by a period of jobless recovery. But true recessions, periods when real GDP falls, are especially
painful for workers. As illustrated by the points to the left of the purple vertical
line in Figure 8-5 (representing years in which the real GDP growth rate is negative), falling real GDP is always associated with a rising rate of unemployment,
causing a great deal of hardship to families.
s
ECONOMICS
223
A jobless recovery is a period in
which the real GDP growth rate is
positive but the unemployment rate
is still rising.
in Action
Failure to Launch
I
n March 2010, when the U.S. job situation was near its worst, the Harvard
Law Record published a brief note titled “Unemployed law student will work
for $160K plus benefits.” In a self-mocking tone, the author admitted to having graduated from Harvard Law School the previous year but not landing a job
offer. “What mark on our résumé is so
bad that it outweighs the crimson H?”
Unemployment Rate for Recent College
the note asked.
FIGURE 8-6
Graduates, 2007–2011
The answer, of course, is that it
wasn’t about the résumé—it was about
Unemployment
the economy. Times of high unemployOver 25
Recent college graduates
rate
ment are especially hard on new gradu18%
ates, who often find it hard to get any
15.5%
16
kind of full-time job.
How bad was it around the time
13.5%
14
12.6%
that note was written? Figure 8-6
11.6%
12
shows unemployment rates for two
10
kinds of college graduates—all gradu7.7%
8
ates 25 and older, and recent graduates
6
in their 20s—for each year from 2007
4.6%
4.5%
4.2%
to 2011. Even at its peak, in October
4
3.0%
2.0%
2009, the unemployment rate among
2
older graduates was less than 5 percent. Among recent graduates, however,
2007
2008
2009
2010
2011
the rate peaked at 15.5 percent, and
Year
it was still well into double digits in
Source: Bureau of Labor Statistics.
late 2011. The U.S. labor market had a
224
PA R T 3
INTRODUCTION TO MACROECONOMICS
Quick Review
• The labor force, equal
to employment plus
unemployment, does not include
discouraged workers. Nor do
labor statistics contain data on
underemployment. The labor
force participation rate is the
percentage of the population age
16 and over in the labor force.
• The unemployment rate is an
indicator of the state of the labor
market, not an exact measure of
the percentage of workers who
can’t find jobs. It can overstate
the true level of unemployment
because workers often spend
time searching for a job even
when jobs are plentiful. But it
can also understate the true level
of unemployment because it
excludes discouraged workers,
marginally attached workers,
and underemployed workers.
• There is a strong negative
relationship between growth
in real GDP and changes in
the unemployment rate. When
growth is above average, the
unemployment rate generally falls.
When growth is below average,
the unemployment rate generally
rises—a period called a jobless
recovery that typically follows a
deep recession.
long way to go before being able to offer college graduates—and young people in
general—the kinds of opportunities they deserved.
Check Your Understanding
8-1
1.Suppose that the advent of employment websites enables job-seekers to find suitable jobs more quickly. What effect will this have on the unemployment rate over
time? Also suppose that these websites encourage job-seekers who had given up
their searches to begin looking again. What effect will this have on the unemployment rate?
2.In which of the following cases is a worker counted as unemployed? Explain.
a. Rosa, an older worker who has been laid off and who gave up looking for work
months ago
b. A nthony, a schoolteacher who is not working during his three-month summer
break
c. Grace, an investment banker who has been laid off and is currently searching
for another position
d. Sergio, a classically trained musician who can only find work playing for local
parties
e. Natasha, a graduate student who went back to school because jobs were scarce
3. Which of the following are consistent with the observed relationship between
growth in real GDP and changes in the unemployment rate as shown in Figure 8-5?
Which are not?
a. A rise in the unemployment rate accompanies a fall in real GDP.
b. A n exceptionally strong business recovery is associated with a greater percentage of the labor force being employed.
c. Negative real GDP growth is associated with a fall in the unemployment rate.
Solutions appear at back of book.
The Natural Rate of Unemployment
Fast economic growth tends to reduce the unemployment rate. So how low can
the unemployment rate go? You might be tempted to say zero, but that isn’t
feasible. Over the past half-century, the national unemployment rate has never
dropped below 2.9%.
How can there be so much unemployment even when many businesses are
having a hard time finding workers? To answer this question, we need to examine
the nature of labor markets and why they normally lead to substantial measured
unemployment even when jobs are plentiful. Our starting point is the observation
that even in the best of times, jobs are constantly being created and destroyed.
Job Creation and Job Destruction
Even during good times, most Americans know someone who has lost his or her job.
In July 2007, the U.S. unemployment rate was only 4.7%, relatively low by historical
standards. Yet in that month there were 4.5 million “job separations”—terminations
of employment that occur because a worker is either fired or quits voluntarily.
There are many reasons for such job loss. One is structural change in the
economy: industries rise and fall as new technologies emerge and consumers’
tastes change. For example, employment in high-tech industries such as telecommunications surged in the late 1990s but slumped severely after 2000. However,
structural change also brings the creation of new jobs: after 2000, the number
of jobs in the American health care sector surged as new medical technologies
and the aging of the population increased the demand for medical care. Poor
management performance or bad luck at individual companies also leads to job
U N E M P L O Y M E N T A N D I N F L AT I O N
225
loss for their employees. For example, in 2009 General Motors
announced plans to eliminate 47,000 jobs after several years
of lagging sales, even as Japanese companies such as Toyota
were opening new plants in North America to meet growing
demand for their cars.
Continual job creation and destruction are a feature of
modern economies, making a naturally occurring amount
of unemployment inevitable. Within this naturally occurring
amount, there are two types of unemployment—frictional and
structural.
Frictional Unemployment
When a worker loses a job involuntarily due to job destruc“At this point, I’m just happy to still have a job”
tion, he or she often doesn’t take the first new job offered. For
example, suppose a skilled programmer, laid off because her
software company’s product line was unsuccessful, sees a help-wanted ad for
clerical work online. She might respond to the ad and get the job—but that would
be foolish. Instead, she should take the time to look for a job that takes advantage
of her skills and pays accordingly. In addition, individual workers are constantly
leaving jobs voluntarily, typically for personal reasons—family moves, dissatisfaction, and better job prospects elsewhere.
Economists say that workers who spend time looking for employment are
engaged in job search. If all workers and all jobs were alike, job search wouldn’t
be necessary; if information about jobs and workers was perfect, job search
would be very quick. In practice, however, it’s normal for a worker who loses a
job, or a young worker seeking a first job, to spend at least a few weeks searching.
Frictional unemployment is unemployment due to the time workers spend in
job search. A certain amount of frictional unemployment is inevitable due to the
constant process of economic change. Thus even in 2007, a year of low unemployment, there were 62 million “job separations,” in which workers left or lost their
jobs. Total employment grew because these separations were more than offset
Workers who spend time looking
for employment are engaged in job
by more than 63 million hires. Inevitably, some of the workers who left or lost
search.
their jobs spent at least some time unemployed, as did some of the workers newly
entering the labor force.
Frictional unemployment is
Figure 8-7 shows the average monthly flows of workers among three states:
unemployment due to the time
workers spend in job search.
employed, unemployed, and not in the labor force during 2007, a year of relatively
FIGURE 8-7
Labor Market Flows in an Average Month in 2007
Even in 2007, a low-unemployment
year, large numbers of workers
moved into and out of both
employment and unemployment each
month. On average, each month
in 2007, 1.781 million unemployed
became employed, and 1.929 million
employed became unemployed.
Employed
4.
ion
1
8
.7
1
ll
mi
9
92
11
3.
ion
92
ll
mi
1.
0
mi
8
mi
lli
on
llio
n
Source: Bureau of Labor Statistics.
Unemployed
1.601 million
1.798 million
Not in
labor force
© The New Yorker Collection 2009 Christopher Weyant from
cartoonbank.com. All Rights Reserved.
CHAPTER 8
226
PA R T 3
INTRODUCTION TO MACROECONOMICS
low unemployment. What the figure suggests is how much churning is constantly
taking place in the labor market. An inevitable consequence of that churning is
a significant number of workers who haven’t yet found their next job—that is,
frictional unemployment.
A limited amount of frictional
unemployment
is relatively harmless
Distribution of the Unemployed by Duration
FIGURE 8-8
and
may
even
be
a good thing. The
of Unemployment, 2007
economy is more productive if workers
take the time to find jobs that are well
In years when the unemployment
rate is low, most unemployed
matched to their skills, and workers
workers are unemployed for
who are unemployed for a brief period
27 weeks
only a short period. In 2007,
while searching for the right job don’t
and over
a year of low unemployment,
experience great hardship. In fact,
18%
Less than
36% of the unemployed had
when there is a low unemployment
5 weeks
15 to
been unemployed for less than
36%
rate, periods of unemployment tend to
26 weeks
5 weeks and 67% for less than
be quite short, suggesting that much of
15%
15 weeks. The short duration
the unemployment is frictional.
of unemployment for most
5 to 14
Figure 8-8 shows the composition
workers suggests that most
weeks
of
unemployment
for all of 2007, when
unemployment in 2007 was
31%
the unemployment rate was only 4.6%.
frictional.
Source: Bureau of Labor Statistics.
Thirty-six percent of the unemployed
had been unemployed for less than
5 weeks, and only 33% had been
unemployed for 15 or more weeks. Only about one in six unemployed workers were considered to be “long-term unemployed”—​u nemployed for 27 or
more weeks.
In periods of higher unemployment, however, workers tend to be jobless
for longer periods of time, suggesting that a smaller share of unemployment is
frictional. Figure 8-9 shows the fraction of the unemployed who had been out
of work for six months or more from 2007 to mid-2014. It jumped to 45% after
the Great Recession, and was still historically high five years after the recession
officially ended.
Percentage of Unemployed U.S. Workers Who Had Been Unemployed
for Six Months or Longer, 2007–2014
14
20
13
20
12
20
11
20
10
20
09
20
08
50%
45
40
35
30
25
20
15
20
Source: Bureau of Labor Statistics.
Long-term unemployed
(percentage of all
unemployed)
07
Before the Great Recession,
relatively few U.S. workers had
been unemployed for long periods.
However, the percentage of longterm unemployed shot up after
2007, and remained high for a
number of years.
20
FIGURE 8-9
Year
CHAPTER 8
U N E M P L O Y M E N T A N D I N F L AT I O N
Structural Unemployment
Frictional unemployment exists even when the number of people seeking jobs
is equal to the number of jobs being offered—that is, the existence of frictional
unemployment doesn’t mean that there is a surplus of labor. Sometimes, however,
there is a persistent surplus of job-seekers in a particular labor market, even when
the economy is at the peak of the business cycle. There may be more workers with
a particular skill than there are jobs available using that skill, or there may be
more workers in a particular geographic region than there are jobs available in
that region. Structural unemployment is unemployment that results when there
are more people seeking jobs in a particular labor market than there are jobs
available at the current wage rate.
The supply and demand model tells us that the price of a good, service, or
factor of production tends to move toward an equilibrium level that matches the
quantity supplied with the quantity demanded. This is equally true, in general,
of labor markets.
Figure 8-10 shows a typical market for labor. The labor demand curve indicates that when the price of labor—the wage rate—increases, employers demand
less labor. The labor supply curve indicates that when the price of labor increases,
more workers are willing to supply labor at the prevailing wage rate. These two
forces coincide to lead to an equilibrium wage rate for any given type of labor in
a particular location. That equilibrium wage rate is shown as WE .
Even at the equilibrium wage rate WE, there will still be some frictional unemployment. That’s because there will always be some workers engaged in job search
even when the number of jobs available is equal to the number of workers seeking
jobs. But there wouldn’t be any structural unemployment in this labor market.
Structural unemployment occurs when the wage rate is, for some reason, persistently above WE . Several factors can lead to a wage rate in excess of WE, the most
important being minimum wages, labor unions, efficiency wages, the side effects
of government policies, and mismatches between employees and employers.
Minimum Wages A minimum wage is a government-mandated floor on the
price of labor. In the United States, the national minimum wage in early 2014 was
$7.25 an hour. A number of state and local governments also determine the minimum wage within their jurisdictions, typically for the purpose of setting it higher
than the federal level. For example, the city of Seattle has set a minimum wage
at $15 an hour. For many American workers, the minimum wage is irrelevant;
the market equilibrium wage for these workers is well above the national price
floor. But for less skilled workers, the minimum wage may be binding—it affects
the wages that people are actually paid and can lead to structural unemployment
in particular markets for labor. Other wealthy countries have higher minimum
wages; for example, in 2014 the French minimum wage was 9.40 euros an hour, or
around $12.40. In these countries, the range of workers for whom the minimum
wage is binding is larger.
Figure 8-10 shows the effect of a binding minimum wage. In this market,
there is a legal floor on wages, WF, which is above the equilibrium wage rate, WE .
This leads to a persistent surplus in the labor market: the quantity of labor supplied, QS, is larger than the quantity demanded, QD. In other words, more people
want to work than can find jobs at the minimum wage, leading to structural
unemployment.
Given that minimum wages—that is, binding minimum wages—generally lead
to structural unemployment, you might wonder why governments impose them.
The rationale is to help ensure that people who work can earn enough income
to afford at least a minimally comfortable lifestyle. However, this may come at
a cost, because it may eliminate the opportunity to work for some workers who
would have willingly worked for lower wages. As illustrated in Figure 8-10, not
only are there more sellers of labor than there are buyers, but there are also fewer
227
In structural unemployment,
more people are seeking jobs in a
particular labor market than there are
jobs available at the current wage
rate, even when the economy is at
the peak of the business cycle.
228
PA R T 3
INTRODUCTION TO MACROECONOMICS
FIGURE 8-10
The Effect of a Minimum Wage on a Labor Market
When the government sets a
minimum wage, WF, that exceeds the
market equilibrium wage rate in that
market, WE, the number of workers
who would like to work at that
minimum wage, QS , is greater than
the number of workers demanded at
that wage rate, QD. This surplus of
labor is structural unemployment.
Wage
rate
Labor supply
Structural
unemployment
WF
E
WE
Minimum
wage
Labor demand
QD
QE
QS Quantity of labor
people working at a minimum wage (QD) than there would have been with no
minimum wage at all (QE).
Although economists broadly agree that a high minimum wage has the
employment-reducing effects shown in Figure 8-10, there is some question about
whether this is a good description of how the U.S. minimum wage actually works.
The minimum wage in the United States is quite low compared with that in
other wealthy countries. For three decades, from the 1970s to the mid-2000s, the
American minimum wage was so low that it was not binding for the vast majority
of workers.
In addition, some researchers have produced evidence showing that increases
in the minimum wage actually lead to higher employment when, as was the
case in the United States at one time, the minimum wage is low compared to
average wages. They argue that firms that employ low-skilled workers sometimes restrict their hiring in order to keep wages low and that, as a result, the
minimum wage can sometimes be increased without any loss of jobs. Most
economists, however, agree that a sufficiently high minimum wage does lead to
structural unemployment.
Labor Unions The actions of labor unions can have effects similar to those of
minimum wages, leading to structural unemployment. By bargaining collectively
for all of a firm’s workers, unions can often win higher wages from employers
than workers would have obtained by bargaining individually. This process,
known as collective bargaining, is intended to tip the scales of bargaining power
more toward workers and away from employers. Labor unions exercise bargaining power by threatening firms with a labor strike, a collective refusal to work.
The threat of a strike can have serious consequences for firms. In such cases,
workers acting collectively can exercise more power than they could if acting
individually.
Employers have acted to counter the bargaining power of unions by threatening and enforcing lockouts—periods in which union workers are locked out and
rendered unemployed—while hiring replacement workers.
When workers have increased bargaining power, they tend to demand and
receive higher wages. Unions also bargain over benefits, such as health care
and pensions, which we can think of as additional wages. Indeed, economists who
CHAPTER 8
U N E M P L O Y M E N T A N D I N F L AT I O N
study the effects of unions on wages find that unionized workers earn higher
wages and more generous benefits than non-union workers with similar skills.
The result of these increased wages can be the same as the result of a minimum
wage: labor unions push the wage that workers receive above the equilibrium
wage. Consequently, there are more people willing to work at the wage being
paid than there are jobs available. Like a binding minimum wage, this leads to
structural unemployment. In the United States, however, due to a low level of
unionization, the amount of unemployment generated by union demands is likely
to be very small.
Efficiency Wages Actions by firms can contribute to structural unemployment.
Firms may choose to pay efficiency wages—wages that employers set above the
equilibrium wage rate as an incentive for their workers to perform better.
Employers may feel the need for such incentives for several reasons. For example, employers often have difficulty observing directly how hard an employee
works. They can, however, elicit more work effort by paying above-market wages:
employees receiving these higher wages are more likely to work harder to ensure
that they aren’t fired, which would cause them to lose their higher wages.
When many firms pay efficiency wages, the result is a pool of workers who
want jobs but can’t find them. So the use of efficiency wages by firms leads to
structural unemployment.
Side Effects of Government Policies In addition, government policies
designed to help workers who lose their jobs can lead to structural unemployment as an unintended side effect. Most economically advanced countries provide
benefits to laid-off workers as a way to tide them over until they find a new job.
In the United States, these benefits typically replace only a small fraction of a
worker’s income and expire after 26 weeks. (This was extended in some cases
to 99 weeks during the period of high unemployment in 2009–2011). In other
countries, particularly in Europe, benefits are more generous and last longer. The
drawback to this generosity is that it reduces a worker’s incentive to quickly find
a new job. During the 1980s, it was often argued that unemployment benefits in
some European countries were one of the causes of Eurosclerosis, persistently
high unemployment that afflicts a number of European economies.
Mismatches Between Employees and Employers It takes time for workers and firms to adjust to shifts in the economy. The result can be a mismatch
between what employees have to offer and what employers are looking for. A
skills mismatch is one form; for example, in the aftermath of the housing bust
of 2009, there were more construction workers looking for jobs than were available. Another form is geographic as in Michigan, which has had a long-standing
surplus of workers after its auto industry declined. Until the mismatch is resolved
through a big enough fall in wages of the surplus workers that induces retraining
or relocation, there will be structural unemployment.
The Natural Rate of Unemployment
Because some frictional unemployment is inevitable and because many economies
also suffer from structural unemployment, a certain amount of unemployment is
normal, or “natural.” Actual unemployment fluctuates around this normal level.
The natural rate of unemployment is the normal unemployment rate around
which the actual unemployment rate fluctuates. It is the rate of unemployment
that arises from the effects of frictional plus structural unemployment. Cyclical
unemployment is the deviation of the actual rate of unemployment from the
natural rate; that is, it is the difference between the actual and natural rates of
unemployment. As the name suggests, cyclical unemployment is the share of
unemployment that arises from the downturns of the business cycle.
229
Efficiency wages are wages that
employers set above the equilibrium
wage rate as an incentive for better
employee performance.
The natural rate of
unemployment is the
unemployment rate that arises from
the effects of frictional plus structural
unemployment.
Cyclical unemployment is the
deviation of the actual rate of
unemployment from the natural rate
due to downturns in the business
cycle.
230
PA R T 3
INTRODUCTION TO MACROECONOMICS
GLOBAL
COMPARISION
Natural Unemployment Around the OECD
T
he Organization for Economic Cooperation and Development
(OECD) is an association of relatively wealthy countries in
Europe and North America that also includes Japan, Korea,
New Zealand, and Australia. Among other activities, the OECD
makes estimates of the natural rate of unemployment. The figure shows these estimates for 2013. The population-weighted
average across the OECD is given by the purple bar.
While the U.S. natural rate of unemployment at 6.1% is
below the OECD average of 7.7%, those of many European
countries (including the major economies of Germany,
Italy, and France) are above average. Many economists
think that persistently high European unemployment rates
are the result of government policies, such as high minimum wages and generous unemployment benefits, which
discourage employers from offering jobs and discourage
workers from accepting jobs, leading to high rates of structural
unemployment.
Estimated natural
unemployment
rate, 2013
18%
16.5%
15.2
16
14
12.3
12
10
8
6
4
4.9 5.3
3.9 4.3
3.8
3.7
3.3
6.8 6.9
6.1 6.4
7
8.4 8.7
7.4 7.6 7.7 7.9
10 10.6
2
No
r
wa
y
K
Ne or
th ea
er
Sw lan
itz ds
er
la
nd
Ja
pa
n
Me
xic
A
o
Un ust
ite rali
a
d
Ne Sta
te
w
Ze s
al
a
Un Ge nd
ite rm
a
d
Ki ny
ng
do
Sw m
ed
e
Ca n
na
da
Ita
ly
OE
CD
Be
lg
iu
m
Fin
la
nd
Ch
ile
Po
la
n
Ire d
la
nd
Sl
ov Gr
e
ak
e
Re ce
pu
bl
ic
Sp
ai
n
0
Source: OECD.
We’ll see in Chapter 16 that an economy’s natural rate of unemployment is
a critical policy variable because a government cannot keep the unemployment
rate persistently below the natural rate without leading to accelerating inflation.
We can summarize the relationships between the various types of unemployment as follows:
(8-3) Natural unemployment =
Frictional unemployment + Structural unemployment
(8-4) Actual unemployment =
Natural unemployment + Cyclical unemployment
Perhaps because of its name, people often imagine that the natural rate of
unemployment is a constant that doesn’t change over time and can’t be affected
by government policy. Neither proposition is true. Let’s take a moment to stress
two facts: the natural rate of unemployment changes over time, and it can be
affected by government policies.
Changes in the Natural Rate of Unemployment
Private-sector economists and government agencies need estimates of the natural
rate of unemployment both to make forecasts and to conduct policy analyses.
Almost all these estimates show that the U.S. natural rate rises and falls over
CHAPTER 8
U N E M P L O Y M E N T A N D I N F L AT I O N
time. For example, the Congressional Budget Office, the independent agency that
conducts budget and economic analyses for Congress, believes that the U.S. natural rate of unemployment was 5.3% in 1950, rose to 6.3% by the end of the 1970s,
but has fallen to 5.2% at the end of 2014. European countries have experienced
even larger swings in their natural rates of unemployment.
What causes the natural rate of unemployment to change? The most important factors are changes in labor force characteristics, changes in labor market
institutions, and changes in government policies. Let’s look briefly at each factor.
Changes in Labor Force Characteristics In 2007 the rate of unemployment
in the United States was 4.6%. Young workers, however, had much higher unemployment rates: 15.7% for teenagers and 8.2% for workers aged 20 to 24. Workers
aged 25 to 54 had an unemployment rate of only 3.7%.
In general, unemployment rates tend to be lower for experienced than for
inexperienced workers. Because experienced workers tend to stay in a given job
longer than do inexperienced ones, they have lower frictional unemployment.
Also, because older workers are more likely than young workers to be family
breadwinners, they have a stronger incentive to find and keep jobs.
One reason the natural rate of unemployment rose during the 1970s was a
large rise in the number of new workers—children of the post–World War II baby
boom entered the labor force, as did a rising percentage of married women. As
Figure 8-11 shows, both the percentage of the labor force less than 25 years old
and the percentage of women in the labor force grew rapidly in the 1970s. By the
end of the 1990s, however, the share of women in the labor force had leveled off
and the percentage of workers under 25 had fallen sharply. As a result, the labor
force as a whole is more experienced today than it was in the 1970s, one likely
reason that the natural rate of unemployment is lower today than in the 1970s.
Changes in Labor Market Institutions As we pointed out earlier, unions that
negotiate wages above the equilibrium level can be a source of structural unemployment. Some economists believe that the high natural rate of unemployment
in Europe, discussed in the Global Comparison, is caused, in part, by strong labor
unions. In the United States, a sharp fall in union membership after 1980 may
have been one reason the natural rate of unemployment fell between the 1970s
and the 1990s.
The Changing Makeup of the U.S. Labor Force, 1948–2014
50%
40
Women
30
Under age 25
20
20
1
20 0
14
00
20
0
19
9
0
19
8
19
70
10
0
Source: Bureau of Labor Statistics.
Percent of
labor force
19
6
In the 1970s the percentage of women
in the labor force rose rapidly, as
did the percentage of those under
age 25. These changes reflected the
entry of large numbers of women into
the paid labor force for the first time
and the fact that baby boomers were
reaching working age. The natural
rate of unemployment may have risen
because many of these workers were
relatively inexperienced. Today, the
labor force is much more experienced,
which is one possible reason the
natural rate has fallen since the 1970s.
19
48
FIGURE 8-11
Year
231
232
PA R T 3
INTRODUCTION TO MACROECONOMICS
Other institutional changes may also be at work. For example, some labor
economists believe that temporary employment agencies, which have proliferated
in recent years, have reduced frictional unemployment by helping match workers
to jobs. Furthermore, as discussed in the Business Case at the end of the chapter,
websites such as Elance-oDesk may have reduced frictional unemployment.
Technological change, coupled with labor market institutions, can also affect the
natural rate of unemployment. Technological change tends to increase the demand
for skilled workers who are familiar with the relevant technology and reduce the
demand for unskilled workers. Economic theory predicts that wages should increase
for skilled workers and decrease for unskilled workers as technology advances. But
if wages for unskilled workers cannot go down—say, due to a binding minimum
wage—increased structural unemployment, and therefore a higher natural rate of
unemployment, will result during periods of faster technological change.
in Action
RLD VIE
O
W
s
ECONOMICS
W
Changes in Government Policies A high minimum wage can cause structural unemployment. Generous unemployment benefits can increase both structural
and frictional unemployment. So government policies intended to help workers
can have the undesirable side effect of raising the natural rate of unemployment.
Some government policies, however, may reduce the natural rate. Two
examples are job training and employment subsidies. Job-training programs are
supposed to provide unemployed workers with skills that widen the range of jobs
they can perform. Employment subsidies are payments either to workers or to
employers that provide a financial incentive to accept or offer jobs.
Structural Unemployment in East Germany
Robert Wallis/Corbis
I
n one of the most dramatic events in world history, a spontaneous popular
uprising in 1989 overthrew the communist dictatorship in East Germany.
Citizens quickly tore down the wall that had divided Berlin, and in short order
East and West Germany united into one democratic nation.
Then the trouble started.
After reunification, employment in East Germany plunged and the unemployment rate soared. This high unemployment rate has gradually come down, but
remains well above the rate in the rest of Germany. In
late 2014 the unemployment rate in what was formerly
East Germany was more than 9%, compared with 5.6%
in the former West Germany. Other parts of formerly
communist Eastern Europe have done much better.
For example, the Czech Republic, which was often cited
along with East Germany as a relatively successful communist economy, had an unemployment rate of only 5.7%
in October 2014. What went wrong in East Germany?
The answer is that, through nobody’s fault, East
Germany found itself suffering from severe structural
unemployment. When Germany was reunified, it became
clear that workers in East Germany were much less productive than their cousins in the west. Yet unions initially demanded and received wage rates equal to those in
West Germany. These wage rates have been slow to come
down because East German workers objected to being
After reunification in 1989, East Germany found itself suffering
treated as inferior to their West German counterparts.
from severe structural unemployment that continues to this day.
Meanwhile, productivity in the former East Germany
remains well below West German levels, in part because of decades of misguided
investment under the former dictatorship. The result has been a persistently
CHAPTER 8
U N E M P L O Y M E N T A N D I N F L AT I O N
large mismatch between the number of workers demanded and the number of
those seeking jobs, and persistently high structural unemployment in the former
East Germany.
Check Your Understanding
8-2
1. Explain the following statements.
a. Frictional unemployment is higher when the pace of technological advance
quickens.
b. Structural unemployment is higher when the pace of technological advance
quickens.
c. Frictional unemployment accounts for a larger share of total unemployment
when the unemployment rate is low.
2.Why does collective bargaining have the same general effect on unemployment as
a minimum wage? Illustrate your answer with a diagram.
3.Suppose that at the peak of the business cycle the United States dramatically
increases benefits for unemployed workers. Explain what will happen to the
natural rate of unemployment.
Solutions appear at back of book.
Inflation and Deflation
As we mentioned in the opening story, monetary officials are perennially divided
between doves and hawks—between those who want to place a high priority on
low unemployment and those who want to place a high priority on low inflation.
It’s easy to see why high unemployment is a problem. But why is inflation something to worry about? Why do policy makers even now get anxious when they see
the inflation rate moving upward? The answer is that inflation can impose costs
on the economy—but not in the way most people think.
233
Quick Review
• Frictional unemployment
occurs because unemployed
workers engage in job search,
making some amount of
unemployment inevitable.
• A variety of factors—minimum
wages, unions, efficiency wages,
the side effects of government
policies such as unemployment
benefits, and mismatches between
employees and employers—lead to
structural unemployment.
• Frictional plus structural
unemployment equals natural
unemployment, yielding a natural
rate of unemployment. In
contrast, cyclical unemployment
changes with the business cycle.
Actual unemployment is equal to
the sum of natural unemployment
and cyclical unemployment.
• The natural rate of
unemployment can shift over
time, due to changes in labor force
characteristics and institutions.
Government policies designed to
help workers are believed to be
one reason for high natural rates
of unemployment in Europe.
The most common complaint about inflation, an increase
in the price level, is that it makes everyone poorer—after
all, a given amount of money buys less. But inflation
does not make everyone poorer. To see why, it’s helpful to imagine what would happen if the United States
did something other countries have done from time to
time—replacing the dollar with a new currency.
An example of this kind of currency conversion happened in 2002, when France, like a number of other
European countries, replaced its national currency, the
franc, with the new pan-European currency, the euro.
People turned in their franc coins and notes, and received
euro coins and notes in exchange, at a rate of precisely
6.55957 francs per euro. At the same time, all contracts
Inflation can distort consumers’ incentives about what and when
were restated in euros at the same rate of exchange. For
to buy.
example, if a French citizen had a home mortgage debt of
500,000 francs, this became a debt of 500,000/6.55957 = 76,224.51 euros. If a worker’s contract specified that he or she should be paid 100 francs per hour, it became
a contract specifying a wage of 100/6.55957 = 15.2449 euros per hour, and so on.
You could imagine doing the same thing here, replacing the dollar with a “new
dollar” at a rate of exchange of, say, 7 to 1. If you owed $140,000 on your home, that
would become a debt of 20,000 new dollars. If you had a wage rate of $14 an hour,
it would become 2 new dollars an hour, and so on. This would bring the overall U.S.
price level back to about what it was in 1962, when John F. Kennedy was president.
AP Photo/Paul Sakuma
The Level of Prices Doesn’t Matter . . .
PA R T 3
INTRODUCTION TO MACROECONOMICS
The real wage is the wage rate
divided by the price level.
Real income is income divided by
the price level.
So would everyone be richer as a result because prices would be only oneseventh as high? Of course not. Prices would be lower, but so would wages and
incomes in general. If you cut a worker’s wage to one-seventh of its previous value,
but also cut all prices to one-seventh of their previous level, the worker’s real
wage—the wage rate divided by the price level—hasn’t changed. In fact, bringing the overall price level back to what it was during the Kennedy administration
would have no effect on overall purchasing power because doing so would reduce
income exactly as much as it reduced prices.
Conversely, the rise in prices that has actually taken place since the early
1960s hasn’t made America poorer because it has also raised incomes by the
same amount: real incomes—incomes divided by the price level—haven’t been
affected by the rise in overall prices.
The moral of this story is that the level of prices doesn’t matter: the United
States would be no richer than it is now if the overall level of prices was still as
low as it was in 1961; conversely, the rise in prices over the past 50 years hasn’t
made us poorer.
. . . But the Rate of Change of Prices Does
The conclusion that the level of prices doesn’t matter might seem to imply that the
inflation rate doesn’t matter either. But that’s not true.
To see why, it’s crucial to distinguish between the level of prices and the inflation rate: the percent increase in the overall level of prices per year. Recall from
Chapter 7 that the inflation rate is defined as follows:
Inflation rate =
Price index in year 2 – Price index in year 1
× 100
Price index in year 1
Figure 8-12 highlights the difference between the price level and the inflation
rate in the United States over the last half-century, with the price level measured
FIGURE 8-12
The Price Level versus the Inflation Rate, 1960–2014
With the exception of 2009, over the
past half-century the price level has
continuously increased. But the inflation
rate—the rate at which prices are rising—
has had both ups and downs. And in
2009, the inflation rate briefly turned
negative, a phenomenon called deflation.
Price
level
Inflation
rate
250
20%
18
Inflation rate
200
16
14
Source: Bureau of Labor Statistics.
12
150
Price level
10
8
100
6
4
50
2
0
0
Deflation in 2009
–2
–4
10
20
14
20
00
20
90
19
80
19
70
19
60
–50
19
234
Year
CHAPTER 8
U N E M P L O Y M E N T A N D I N F L AT I O N
along the left vertical axis and the inflation rate measured along the right vertical
axis. In the 2000s, the overall level of prices in America was much higher than it
had been in 1960—but that, as we’ve learned, didn’t matter. The inflation rate in
the 2000s, however, was much lower than in the 1970s—and that almost certainly
made the economy richer than it would have been if high inflation had continued.
Economists believe that high rates of inflation impose significant economic
costs. The most important of these costs are shoe-leather costs, menu costs, and
unit-of-account costs. We’ll discuss each in turn.
Shoe-Leather Costs People hold money—cash in their wallets and bank
deposits on which they can write checks—for convenience in making transactions. A high inflation rate, however, discourages people from holding money
because the purchasing power of the cash in your wallet and the funds in your
bank account steadily erode as the overall level of prices rises. This leads people
to search for ways to reduce the amount of money they hold, often at considerable
economic cost.
The upcoming Economics in Action describes how Israelis spent a lot of time
at the bank during the periods of high inflation rates that afflicted Israel in
1984–1985. During the most famous of all inflations, the German hyperinflation
of 1921–1923, merchants employed runners to take their cash to the bank many
times a day to convert it into something that would hold its value, such as a stable
foreign currency. In each case, in an effort to avoid having the purchasing power
of their money eroded, people used up valuable resources, such as time for Israeli
citizens and the labor of those German runners that could have been used productively elsewhere. During the German hyperinflation, so many banking transactions were taking place that the number of employees at German banks nearly
quadrupled—from around 100,000 in 1913 to 375,000 in 1923.
More recently, Brazil experienced hyperinflation during the early 1990s; during that episode, the Brazilian banking sector grew so large that it accounted for
15% of GDP, more than twice the size of the financial sector in the United States
measured as a share of GDP. The large increase in the Brazilian banking sector needed to cope with the consequences of inflation represented a loss of real
resources to its society.
Increased costs of transactions caused by inflation are known as shoe-leather
costs, an allusion to the wear and tear caused by the extra running around that
takes place when people are trying to avoid holding money. Shoe-leather costs
are substantial in economies with very high inflation, as anyone who has lived
in such an economy—say, one suffering inflation of 100% or more per year—can
attest. Most estimates suggest, however, that the shoe-leather costs of inflation at
the rates seen in the United States—which in peacetime has never had inflation
above 15%—are quite small.
Menu Costs In a modern economy, most of the things we buy have a listed
price. There’s a price listed under each item on a supermarket shelf, a price
printed on the back of a book, and a price listed for each dish on a restaurant’s
menu. Changing a listed price has a real cost, called a menu cost. For example,
to change prices in a supermarket requires sending clerks through the store to
change the listed price under each item. In the face of inflation, of course, firms
are forced to change prices more often than they would if the aggregate price
level was more or less stable. This means higher costs for the economy as a whole.
In times of very high inflation, menu costs can be substantial. During the
Brazilian inflation of the early 1990s, for instance, supermarket workers reportedly spent half of their time replacing old price stickers with new ones. When
inflation is high, merchants may decide to stop listing prices in terms of the local
currency and use either an artificial unit—in effect, measuring prices relative to
one another—or a more stable currency, such as the U.S. dollar. This is exactly
what the Israeli real estate market began doing in the mid-1980s: prices were
235
Shoe-leather costs are the
increased costs of transactions
caused by inflation.
The menu cost is the real cost of
changing a listed price.
236
PA R T 3
INTRODUCTION TO MACROECONOMICS
quoted in U.S. dollars, even though payment
was made in Israeli shekels. And this is also
what happened in Zimbabwe when, in May
2008, official estimates of the inflation rate
reached 1,694,000%. By 2009, the government
had suspended the Zimbabwean dollar, allowing Zimbabweans to buy and sell goods using
foreign currencies.
Menu costs are also present in lowinflation economies, but they are not severe.
In low-inflation economies, businesses might
update their prices only sporadically—not
daily or even more frequently, as is the case
in high-inflation or hyperinflation economies.
When one hundred trillion dollar bills are in circulation as they were in
Also, with the growing popularity of online
Zimbabwe, menu costs are substantial.
shopping, menu costs are becoming less and
less important, since prices can be changed electronically and fewer merchants
attach price stickers to merchandise.
Unit-of-Account Costs In the Middle Ages, contracts were often specified
Unit-of-account costs arise from
the way inflation makes money a less
reliable unit of measurement.
“in kind”: a tenant might, for example, be obliged to provide his landlord with a
certain number of cattle each year (the phrase in kind actually comes from an
ancient word for cattle). This may have made sense at the time, but it would be an
awkward way to conduct modern business. Instead, we state contracts in monetary terms: a renter owes a certain number of dollars per month, a company that
issues a bond promises to pay the bondholder the dollar value of the bond when
it comes due, and so on. We also tend to make our economic calculations in dollars: a family planning its budget, or a small business owner trying to figure out
how well the business is doing, makes estimates of the amount of money coming
in and going out.
This role of the dollar as a basis for contracts and calculation is called the
unit-of-account role of money. It’s an important aspect of the modern economy.
Yet it’s a role that can be degraded by inflation, which causes the purchasing
power of a dollar to change over time—a dollar next year is worth less than a dollar this year. The effect, many economists argue, is to reduce the quality of economic decisions: the economy as a whole makes less efficient use of its resources
because of the uncertainty caused by changes in the unit of account, the dollar.
The unit-of-account costs of inflation are the costs arising from the way inflation
makes money a less reliable unit of measurement.
Unit-of-account costs may be particularly important in the tax system
because inflation can distort the measures of income on which taxes are collected. Here’s an example: assume that the inflation rate is 10%, so the overall
level of prices rises 10% each year. Suppose that a business buys an asset, such
as a piece of land, for $100,000, then resells it a year later for $110,000. In a
fundamental sense, the business didn’t make a profit on the deal: in real terms,
it got no more for the land than it paid for it. But U.S. tax law would say that
the business made a capital gain of $10,000, and it would have to pay taxes on
that phantom gain.
During the 1970s, when the United States had relatively high inflation, the
distorting effects of inflation on the tax system were a serious problem. Some
businesses were discouraged from productive investment spending because they
found themselves paying taxes on phantom gains. Meanwhile, some unproductive
investments became attractive because they led to phantom losses that reduced
tax bills. When inflation fell in the 1980s—and tax rates were reduced—these
problems became much less important.
CHAPTER 8
U N E M P L O Y M E N T A N D I N F L AT I O N
Winners and Losers from Inflation
As we’ve just learned, a high inflation rate imposes overall costs on the economy.
In addition, inflation can produce winners and losers within the economy. The
main reason inflation sometimes helps some people while hurting others is that
economic transactions often involve contracts that extend over a period of time,
such as loans, and these contracts are normally specified in nominal—that is, in
dollar—terms.
In the case of a loan, the borrower receives a certain amount of funds at the
beginning, and the loan contract specifies the interest rate on the loan and when
it must be paid off. The interest rate is the return a lender receives for allowing
borrowers the use of their savings for one year, calculated as a percentage of the
amount borrowed.
But what that dollar is worth in real terms—that is, in terms of purchasing
power—depends greatly on the rate of inflation over the intervening years of the
loan. Economists summarize the effect of inflation on borrowers and lenders
by distinguishing between the nominal interest rate and the real interest rate.
The nominal interest rate is the interest rate in dollar terms—for example, the
interest rate on a student loan. The real interest rate is the nominal interest rate
minus the rate of inflation. For example, if a loan carries an interest rate of 8%,
but there is 5% inflation, the real interest rate is 8% − 5% = 3%.
When a borrower and a lender enter into a loan contract, the contract is normally written in dollar terms—that is, the interest rate it specifies is a nominal
interest rate. (And in later chapters, when we say the interest rate we will mean
the nominal interest rate unless noted otherwise.) But each party to a loan
contract has an expectation about the future rate of inflation and therefore an
expectation about the real interest rate on the loan. If the actual inflation rate is
higher than expected, borrowers gain at the expense of lenders: borrowers will
repay their loans with funds that have a lower real value than had been expected.
Conversely, if the inflation rate is lower than expected, lenders will gain at the
expense of borrowers: borrowers must repay their loans with funds that have a
higher real value than had been expected.
Historically, the fact that inflation creates winners and losers has sometimes
been a major source of political controversy. In 1896 William Jennings Bryan
electrified the Democratic presidential convention with a speech in which he
declared, “You shall not crucify mankind on a cross of gold.” What he was actually demanding was an inflationary policy. At the time, the U.S. dollar had a fixed
value in terms of gold. Bryan wanted to abandon that gold standard and have the
U.S. government print more money, which would have raised the level of prices.
The reason he wanted inflation was to help farmers, many of whom were deeply
in debt.
In modern America, home mortgages are the most important source of gains
and losses from inflation. Americans who took out mortgages in the early 1970s
quickly found their real payments reduced by higher-than-expected inflation: by
1983, the purchasing power of a dollar was only 45% of what it had been in 1973.
Those who took out mortgages in the early 1990s were not so lucky, because the
inflation rate fell to lower-than-expected levels in the following years: in 2003 the
purchasing power of a dollar was 78% of what it had been in 1993.
Because gains for some and losses for others result from inflation that is
either higher or lower than expected, yet another problem arises: uncertainty
about the future inflation rate discourages people from entering into any form of
long-term contract. This is an additional cost of high inflation, because high rates
of inflation are usually unpredictable. In countries with high and uncertain inflation, long-term loans are rare, which makes it difficult in many cases to make
long-term investments.
237
The interest rate on a loan is the
price, calculated as a percentage of
the amount borrowed, that lenders
charge borrowers the use of their
savings for one year.
The nominal interest rate is the
interest rate expressed in dollar
terms.
The real interest rate is the
nominal interest rate minus the rate
of inflation.
238
PA R T 3
INTRODUCTION TO MACROECONOMICS
Disinflation is the process of
bringing the inflation rate down.
One last point: unexpected deflation—a surprise fall in the price level—creates
winners and losers, too. Between 1929 and 1933, as the U.S. economy plunged into
the Great Depression, the consumer price index fell by 35%. This meant that debtors, including many farmers and homeowners, saw a sharp rise in the real value
of their debts, which led to widespread bankruptcy and helped create a banking
crisis, as lenders found their customers unable to pay back their loans. And as
you can see in Figure 8-12, deflation occurred again in 2009, when the inflation
rate fell to −2% at the trough of a deep recession. Like the Great Depression (but
to a much lesser extent), the unexpected deflation of 2009 imposed heavy costs
on debtors. We will discuss the effects of deflation in more detail in Chapter 16.
Inflation Is Easy; Disinflation Is Hard
There is not much evidence that a rise in the inflation rate from, say, 2% to 5%
would do a great deal of harm to the economy. Still, policy makers generally
move forcefully to bring inflation back down when it creeps above 2% or 3%.
Why? Because experience shows that bringing the inflation rate down—a process
called disinflation—is very difficult and costly once a higher rate of inflation has
become well established in the economy.
Figure 8-13 shows what happened during two major episodes of disinflation
in the United States, in the mid-1970s and in the early 1980s. The horizontal axis
shows the unemployment rate. The vertical axis shows “core” inflation over the
previous year, a measure that excludes volatile food and energy prices and is
widely considered a better measure of underlying inflation than overall consumer
prices. Each marker represents the inflation rate and the unemployment rate for
one month. In each episode, unemployment and inflation followed a sort of clockwise spiral, with high inflation gradually falling in the face of an extended period
of very high unemployment.
According to many economists, these periods of high unemployment that
temporarily depressed the economy were necessary to reduce inflation that had
become deeply embedded in the economy. The best way to avoid having to put
the economy through a wringer to reduce inflation, however, is to avoid having a
serious inflation problem in the first place. So policy makers respond forcefully
to signs that inflation may be accelerating as a form of preventive medicine for
the economy.
FIGURE 8-13
The Cost of Disinflation
There were two major periods of
disinflation in modern U.S. history, in
the mid-1970s and the early 1980s.
This figure shows the track of the
unemployment rate and the “core” inflation
rate, which excludes food and energy,
during these two episodes. In each
case bringing inflation down required a
temporary but very large increase in the
unemployment rate, demonstrating the
high cost of disinflation.
Source: Bureau of Labor Statistics.
Inflation
rate
14%
12
10
January
1980
1970s
August
1974
8
March
1978
6
4
2
0
August
1987
5
1980s
6
7
8
9
10
11%
Unemployment rate
in Action
U N E M P L O Y M E N T A N D I N F L AT I O N
239
RLD VIE
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ECONOMICS
W
CHAPTER 8
Israel’s Experience With Inflation
Check Your Understanding
• Inflation, like unemployment,
8-3
1.
The widespread use of technology has revolutionized the banking industry, making
it much easier for customers to access and manage their assets. Does this mean
that the shoe-leather costs of inflation are higher or lower than they used to be?
2.Most people in the United States have grown accustomed to a modest inflation rate
of around 2% to 3%. Who would gain and who would lose if inflation unexpectedly
came to a complete stop over the next 15 or 20 years?
Solutions appear at back of book.
is a major concern of policy
makers—so much so that in the
past they have accepted high
unemployment as the price of
reducing inflation.
• While the overall level of prices
is irrelevant, high rates of inflation
impose real costs on the economy:
shoe-leather costs, menu costs,
and unit-of-account costs.
• The interest rate is the return
a lender receives for use of his
or her funds for a year. The real
interest rate is equal to the
nominal interest rate minus
the inflation rate. As a result,
unexpectedly high inflation helps
borrowers and hurts lenders.
With high and uncertain inflation,
people will often avoid long-term
investments.
• Disinflation is very costly, so
policy makers try to avoid getting
into situations of high inflation in
the first place.
Ricki Rosen/Corbis Saba
I
t’s often hard to see the costs of inflation clearly because serious inflation
problems are often associated with other problems that disrupt economic
life, notably war or political instability (or both). In the mid-1980s, however,
Israel experienced a “clean” inflation: there was no war,
the government was stable, and there was order in the
streets. Yet a series of policy errors led to very high inflation, with prices often rising more than 10% a month.
As it happens, one of the authors spent a month visiting at Tel Aviv University at the height of the inflation, so
we can give a first-hand account of the effects.
First, the shoe-leather costs of inflation were substantial. At the time, Israelis spent a lot of time in lines
at the bank, moving money in and out of accounts that
provided high enough interest rates to offset inflation.
People walked around with very little cash in their
wallets; they had to go to the bank whenever they
needed to make even a moderately large cash payment.
Banks responded by opening a lot of branches, a costly
business expense.
The shoe-leather costs of inflation in Israel: when the inflation rate
Second, although menu costs weren’t that visible to
hit 500% in 1985, people spent a lot of time in line at banks.
a visitor, what you could see were the efforts businesses
made to minimize them. For example, restaurant menus often didn’t list prices.
Instead, they listed numbers that you had to multiply by another number, written
on a chalkboard and changed every day, to figure out the price of a dish.
Finally, it was hard to make decisions because prices changed so much and
Quick Review
so often. It was a common experience to walk out of a store because prices were
• The real wage and real
25% higher than at one’s usual shopping destination, only to discover that prices
income are unaffected by the level
had just been increased 25% there, too.
of prices.
BUSINESS
CASE
Day Labor in the Information Age
B
14
20
20
10
06
20
02
20
19
98
94
19
19
90
The Photo Works
y the usual measures, California-based Elance-oDesk is
a pretty small business, with only 250 employees. But in
mid-2014 it was supplying workers to 2.5 million businesses. Elance-oDesk could do that because it doesn’t offer
services directly; instead, it operates as an online marketplace,
matching employers with freelance workers.
While most American workers consistently work for a single
employer, temporary workers have always accounted for a significant portion of the labor force. On urban street corners across
America, workers line up early each morning in the hope of getting day jobs in industries like construction where the need for
workers fluctuates, sometimes unpredictably. For more skilled
workers, there are temporary staffing agencies like Allegis Group
that provide workers on a subcontracting basis, from a few days
to months at a time. Figure 8-14 shows the share of temporary
employment accounted for by these agencies in total employment. As you can see, in the late stages of the economic expansion
in the 1990s and the 2000s, temporary employment soared as
companies needed more workers but had difficulty hiring permanent employees
in a tight labor market. Temporary employment then proceeded to plunge once
demand for additional workers fell off.
At first glance, the rapid growth of tempoThe Rise in Temporary Employment,
FIGURE 8-14
rary employment since the end of the 2007–
1990–2014
2009 recession might seem to follow the same
pattern. But this time companies were hiring
Percent
temporary workers in a weak labor market.
of total
employment
With more than three times as many Americans
2.5%
seeking work as there were job openings, companies shouldn’t have had any trouble hiring.
2.0
So why the surge in temp work?
1.5
One answer may be the way in which
advances in technology have opened up a new
1.0
breed of services. Manual laborers might still
be lining up on street corners, but information
0.5
technology workers and other professionals
were increasingly finding temporary, freelance
work through web-based services like the two
Year
companies Elance (e-commerce + freelance—
Source: Bureau of Labor Statistics.
get it?) and oDesk, which merged in 2014.
By 2014 Elance-oDesk was serving more than 8 million workers (three-quarters
of them outside the United States), twice as many as in 2012. Growth like that
indicates the economy may be undergoing a fundamental shift in the way work
is structured, one in which temporary arrangements of convenience replace longterm commitment.
QUESTIONS FOR THOUGHT
1. Use the flows shown in Figure 8-7 to explain the role of temporary staffing
in the economy.
2. What is the likely effect of improved matching of job-seekers and employers
through online services listings on the unemployment rate?
3. What does the fact that temporary staffing fell sharply during the 2008–2009
surge in unemployment suggest about the nature of that surge?
240
CHAPTER 8
U N E M P L O Y M E N T A N D I N F L AT I O N
241
SUMMARY
1. The twin goals of reducing inflation and unemployment
are the main concerns of macroeconomic policy.
2. Employment is the number of people employed;
unemployment is the number of people unemployed
and actively looking for work. Their sum is equal to the
labor force, and the labor force participation rate is
the percentage of the population age 16 or older that is
in the labor force.
3. The unemployment rate, the percentage of the labor
force that is unemployed and actively looking for work,
can both overstate and understate the true level of
unemployment. It can overstate because it counts as
unemployed those who are continuing to search for a
job despite having been offered one. It can understate
because it ignores frustrated workers, such as discouraged workers, marginally attached workers, and the
underemployed. In addition, the unemployment rate
varies greatly among different groups in the population; it is typically higher for younger workers and for
workers near retirement age than for workers in their
prime working years.
4. The unemployment rate is affected by the business
cycle. The unemployment rate generally falls when the
growth rate of real GDP is above average and generally
increases when the growth rate of real GDP is below
average. A jobless recovery, a period in which real
GDP is growing but unemployment rises, often follows
recessions.
5. Job creation and destruction, as well as voluntary job
separations, lead to job search and frictional unemployment. In addition, a variety of factors such as
minimum wages, unions, efficiency wages, government policies designed to help laid-off workers, and
mismatch between employees and employers result in
a situation in which there is a surplus of labor at the
market wage rate, creating structural unemployment.
As a result, the natural rate of unemployment, the
sum of frictional and structural unemployment, is well
above zero, even when jobs are plentiful.
6. The actual unemployment rate is equal to the natural
rate of unemployment, the share of unemployment
that is independent of the business cycle, plus cyclical unemployment, the share of unemployment that
depends on fluctuations in the business cycle.
7. The natural rate of unemployment changes over time,
largely in response to changes in labor force characteristics, labor market institutions, and government
policies.
8. Inflation does not, as many assume, make everyone
poorer by raising the level of prices. That’s because
wages and incomes are adjusted to take into account a
rising price level, leaving real wages and real income
unaffected. However, a high inflation rate imposes
overall costs on the economy: shoe-leather costs,
menu costs, and unit-of-account costs.
9. Inflation can produce winners and losers within the
economy, because long-term contracts are generally
written in dollar terms. The interest rate specified in a
loan is typically a nominal interest rate, which differs
from the real interest rate due to inflation. A higherthan-expected inflation rate is good for borrowers and
bad for lenders. A lower-than-expected inflation rate is
good for lenders and bad for borrowers.
10. Many believe policies that depress the economy and
produce high unemployment are necessary to reduce
embedded inflation. Because disinflation is very costly, policy makers try to prevent inflation from becoming excessive in the first place.
KEY TERMS
Employment, p. 218
Unemployment, p. 218
Labor force, p. 219
Labor force participation rate, p. 219
Unemployment rate, p. 219
Discouraged workers, p. 220
Marginally attached workers, p. 220
Underemployment, p. 220
Jobless recovery, p. 223
Job search, p. 225
Frictional unemployment, p. 225
Structural unemployment, p. 227
Efficiency wages, p. 229
Natural rate of unemployment, p. 229
Cyclical unemployment, p. 229
Real wage, p. 234
Real income, p. 234
Shoe-leather costs, p. 235
Menu costs, p. 235
Unit-of-account costs, p. 236
Interest rate, p. 237
Nominal interest rate, p. 237
Real interest rate, p. 237
Disinflation, p. 238
242
PA R T 3
INTRODUCTION TO MACROECONOMICS
PROBLEMS
1. Each month, usually on the first Friday of the month,
5. A country’s labor force is the sum of the number of
the Bureau of Labor Statistics releases the Employment
Situation Summary for the previous month. Go to
www.bls.gov and find the latest report. On the Bureau
of Labor Statistics home page, at the top of the page,
select the “Subjects” tab, find “Unemployment,” and
select “National Unemployment Rate.” You will find
the Employment Situation Summary under “CPS News
Releases” on the left-hand side of the page. How does
the current unemployment rate compare to the rate one
month earlier? How does the current unemployment
rate compare to the rate one year earlier?
employed and unemployed workers. The accompanying
table provides data on the size of the labor force and the
number of unemployed workers for different regions of
the United States.
2. In general, how do changes in the unemployment rate
vary with changes in real GDP? After several quarters
of a severe recession, explain why we might observe a
decrease in the official unemployment rate. Explain
why we could see an increase in the official unemployment rate after several quarters of a strong expansion.
3. In each of the following situations, what type of unem-
ployment is Melanie facing?
a. After completing a complex programming project,
Melanie is laid off. Her prospects for a new job
requiring similar skills are good, and she has signed
up with a programmer placement service. She has
passed up offers for low-paying jobs.
b. When Melanie and her co-workers refused to accept
pay cuts, her employer outsourced their programming tasks to workers in another country. This phenomenon is occurring throughout the programming
industry.
c. Due to the current slump, Melanie has been laid off
from her programming job. Her employer promises
to rehire her when business picks up.
4. Part of the information released in the Employment
Situation Summary concerns how long individuals
have been unemployed. Go to www.bls.gov to find the
latest report. Use the same technique as in Problem 1 to
find the Employment Situation Summary. Near the end
of the Employment Situation, click on Table A-12, titled
“Unemployed persons by duration of unemployment.”
Use the seasonally adjusted numbers to answer the following questions.
a. How many workers were unemployed less than 5
weeks? What percentage of all unemployed workers
do these workers represent? How do these numbers
compare to the previous month’s data?
b. How many workers were unemployed for 27 or more
weeks? What percentage of all unemployed workers
do these workers represent? How do these numbers
compare to the previous month’s data?
Labor force
(thousands)
April 2013
April 2014
Unemployed
(thousands)
April 2013
April 2014
Northeast
28,407.2
28,288.9
2,174.4
1,781.3
South
56,787.8
57,016.4
4,089.9
3,363.8
Midwest
34,320.0
34,467.0
2,473.7
2,109.0
West
36,122.2
36,307.3
2,940.8
2,535.7
Region
Source: Bureau of Labor Statistics.
a. Calculate the number of workers employed in each
of the regions in April 2013 and April 2014. Use your
answers to calculate the change in the total number
of workers employed between April 2013 and April
2014.
b. For each region, calculate the growth in the labor
force from April 2013 to April 2014.
c. Compute unemployment rates in the different
regions of the country in April 2013 and April 2014.
d. What can you infer about the fall in unemployment
rates over this period? Was it caused by a net gain in
the number of jobs or by a large fall in the number
of people seeking jobs?
6. In which of the following cases is it more likely for effi-
ciency wages to exist? Why?
a. Jane and her boss work as a team selling ice cream.
b. Jane sells ice cream without any direct supervision
by her boss.
c. Jane speaks Korean and sells ice cream in a neigh-
borhood in which Korean is the primary language.
It is difficult to find another worker who speaks
Korean.
7. How will the following changes affect the natural rate
of unemployment?
a. The government reduces the time during which an
unemployed worker can receive unemployment
benefits.
b. More teenagers focus on their studies and do not
look for jobs until after college.
c. Greater access to the internet leads both potential
employers and potential employees to use the internet to list and find jobs.
d. Union membership declines.
c. How long has the average worker been unemployed
8. With its tradition of a job for life for most citizens,
(average duration, in weeks)? How does this compare to the average for the previous month’s data?
Japan once had a much lower unemployment rate
than that of the United States; from 1960 to 1995, the
unemployment rate in Japan exceeded 3% only once.
However, since the crash of its stock market in 1989
and slow economic growth in the 1990s, the job-for-life
d. Comparing the latest month for which there are data
with the previous month, has the problem of longterm unemployment improved or deteriorated?
CHAPTER 8
Inflation rate,
interest rate
10
8
6
13
20
10
20
07
98
19
Year
2.7%
11. The accompanying table provides the inflation rate in
2.2%
1.9%
2
1.8%
1.4%
1
0
20
2
Interest rate on
one-year loans
04
4
Real GDP
growth rate
3%
Inflation
rate
12%
20
growth of real GDP picked up in Japan after 2001
and before the global economic crisis of 2007–2009.
Explain the likely effect of this increase in real GDP
growth on the unemployment rate. Was the likely
cause of the change in the unemployment rate during this period a change in the natural rate of unemployment or a change in the cyclical unemployment
rate?
one-year loans and inflation during 1998–2013 in the
economy of Albernia. When would one-year loans have
been especially attractive and why?
01
b. As the accompanying diagram shows, the rate of
10. The accompanying diagram shows the interest rate on
20
system has broken down and unemployment rose to
more than 5% in 2003.
a. Explain the likely effect of the breakdown of the jobfor-life system in Japan on the Japanese natural rate
of unemployment.
0.2%
0.3%
2001
2002
2003
2004
243
U N E M P L O Y M E N T A N D I N F L AT I O N
2005
2006
2007
Year
Source: OECD.
9. In the following examples, is inflation creating winners
the year 2000 and the average inflation rate over the
period 2001–2013 for seven different countries.
Country
Inflation rate
in 2000
Average inflation
rate in 2001–2013
Brazil
7.06%
6.72%
China
0.4
2.34
France
1.83
1.86
Indonesia
3.77
7.56
Japan
−0.78
−0.23
Turkey
55.03
18.79
United States
3.37
2.43
and losers at no net cost to the economy or is inflation
imposing a net cost on the economy? If a net cost is
being imposed, which type of cost is involved?
a. When inflation is expected to be high, workers get
paid more frequently and make more trips to the
bank.
a. Given the expected relationship between average
b. Lanwei is reimbursed by her company for her work-
b. Rank the countries in order of inflation rates that
related travel expenses. Sometimes, however, the
company takes a long time to reimburse her. So
when inflation is high, she is less willing to travel for
her job.
c. Hector Homeowner has a mortgage with a fixed
nominal 6% interest rate that he took out five years
ago. Over the years, the inflation rate has crept up
unexpectedly to its present level of 7%.
d. In response to unexpectedly high inflation, the
manager of Cozy Cottages of Cape Cod must reprint
and resend expensive color brochures correcting the
price of rentals this season.
Source: IMF.
inflation and menu costs, rank the countries in
descending order of menu costs using average inflation over the period 2001–2013.
most favored borrowers with ten-year loans that
were taken out in 2000. Assume that the loans were
agreed upon with the expectation that the inflation
rate for 2001 to 2013 would be the same as the inflation rate in 2000.
c. Did borrowers who took out ten-year loans in Japan
gain or lose overall versus lenders? Explain.
244
PA R T 3
INTRODUCTION TO MACROECONOMICS
12. The accompanying diagram shows the inflation rate in
the United Kingdom from 1980 to 2013.
For interactive, step-by-step help in solving the following problem,
visit
by using the URL on the back cover of this book.
Inflation
rate
13. There is only one labor market in Profunctia. All
workers have the same skills, and all firms hire workers with these skills. Use the accompanying diagram,
which shows the supply of and demand for labor,
to answer the following questions. Illustrate each
answer with a diagram.
18%
16
14
12
10
8
6
4
2
1980
WORK IT OUT
Wage
rate
S
$20
1990
2000
2010 2013
Year
10
Source: IMF.
a. Between 1980 and 1985, policy makers in the United
Kingdom worked to lower the inflation rate. What
would you predict happened to unemployment
between 1980 and 1985?
0
D
50
100
Quantity of labor
(thousands)
b. Policy makers in the United Kingdom react forceful-
ly when the inflation rate rises above a target rate of
2%. Why would it be harmful if inflation rose from
2.6% (the level in 2013) to, say, a level of 5%?
a. What is the equilibrium wage rate in Profunctia?
At this wage rate, what are the level of employment, the size of the labor force, and the unemployment rate?
b. If the government of Profunctia sets a mini-
mum wage equal to $12, what will be the level of
employment, the size of the labor force, and the
unemployment rate?
c. If unions bargain with the firms in Profunctia
and set a wage rate equal to $14, what will be the
level of employment, the size of the labor force,
and the unemployment rate?
d. If the concern for retaining workers and encour-
aging high-quality work leads firms to set a
wage rate equal to $16, what will be the level of
employment, the size of the labor force, and the
unemployment rate?
9
RLD VIE
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Long-Run Economic Growth
CHAPTER
AIRPOCALYPSE NOW
s
What You Will Learn
in This Chapter
long-run economic growth
•is Why
measured as the increase in
real GDP per capita, how real
GDP per capita has changed over
time, and how it varies across
countries
Why productivity is the key to
•long-run
economic growth and
how productivity is driven by
physical capital, human capital,
and technological progress
much among countries
How growth has varied among
•several
important regions of the
world and why the convergence
hypothesis applies to
economically advanced countries
•
The question of sustainability
and the challenges to growth
posed by scarcity of natural
resources and environmental
degradation
O
epa european pressphoto agency b.v./Alamy
The factors that explain why
•long-run
growth rates differ so
Rapid, uncontrolled economic growth has resulted in much higher living standards in
China but at the cost of very high levels of pollution.
n January 16, 2014, reported the
New York Times, “Some residents
of Beijing woke up with splitting
headaches. A curtain of haze had fallen
across the city of more than 20 million. It
was the first ‘airpocalypse’ of the year in
the Chinese capital and nearby provinces.”
As the article suggested, severe air
pollution—at levels that make the oncefamous smog of Los Angeles (mostly
gone now thanks to pollution regulations) seem mild by comparison—has
become commonplace in China’s cities.
This is, it goes without saying, a bad
thing, and must be dealt with. But it is a
byproduct of a very good thing: China’s
extraordinary economic growth in the
past few decades, which has raised literally hundreds of millions of people out
of abject poverty. These newly enriched
masses want what everyone wants if
they can afford it: better food, better housing, and consumer goods—including, in
many cases, cars. As recently as 1999
there were fewer than 15 million motor
vehicles in China, barely 1 for every
100 people. By 2012 that number had
risen to 240 million, and was still rising fast.
Unfortunately, the growth in China’s
car population has run ahead of its pollution controls. And the result, combined
with the emissions of the country’s burgeoning industry, is epochal smog.
Despite its troubling environmental
problems, China has obviously made
enormous economic strides over the past
few decades. Indeed, its recent history
is probably the world’s most impressive
example to date of long-run economic
growth—a sustained increase in output
per capita. Yet despite its impressive
performance, China is currently playing
catch-up with economically advanced
countries like the United States and
Japan. It’s still a relatively poor country
because these other nations began their
own processes of long-run economic
growth many decades ago—and in the
case of the United States and European
countries, more than a century ago.
Many economists have argued that
long-run economic growth—why it happens and how to achieve it—is the single
most important issue in macroeconomics. In this chapter, we present some
facts about long-run growth, look at the
factors that economists believe determine the pace at which long-run growth
takes place, examine how government
policies can help or hinder growth, and
address questions about the environmental sustainability of long-run growth.
245
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Comparing Economies Across
Time and Space
Before we analyze the sources of long-run economic growth, it’s useful to have a
sense of just how much the U.S. economy has grown over time and how large the
gaps are between wealthy countries like the United States and countries that have
yet to achieve comparable growth. So let’s take a look at the numbers.
Real GDP per Capita
The key statistic used to track economic growth is real GDP per capita—real
GDP divided by the population size. We focus on GDP because, as we learned
in Chapter 7, GDP measures the total value of an economy’s production of final
goods and services as well as the income earned in that economy in a given year.
We use real GDP because we want to separate changes in the quantity of goods
and services from the effects of a rising price level. We focus on real GDP per
capita because we want to isolate the effect of changes in the population. For
example, other things equal, an increase in the population lowers the standard of
living for the average person—there are now more people to share a given amount
of real GDP. An increase in real GDP that only matches an increase in population
leaves the average standard of living unchanged.
Although we also learned in Chapter 7 that growth in real GDP per capita
should not be a policy goal in and of itself, it does serve as a very useful summary
measure of a country’s economic progress over time. Figure 9-1 shows real GDP
per capita for the United States, India, and China, measured in 1990 dollars, from
1900 to 2010. (We’ll talk about India and China in a moment.) The vertical axis is
drawn on a logarithmic scale so that equal percent changes in real GDP per capita
across countries are the same size in the graph.
To give a sense of how much the U.S. economy grew during the last century,
Table 9-1 shows real GDP per capita at selected years, expressed two ways: as a
percentage of the 1900 level and as a percentage of the 2010 level. In 1920, the U.S.
economy already produced 136% as much per person as it did in 1900. In 2010,
Economic Growth in the United States, India, and China over the Past Century
World War II
United States
10,000
China
1,000
20
10
20
00
19
90
19
80
19
70
19
60
19
50
19
40
19
30
India
19
20
Sources: Angus Maddison, Statistics on
World Population, GDP, and Per Capita GDP,
1–2008AD, http://www.ggdc.net/maddison; The
Conference Board Total Economy Database™,
January 2014, http://www.conference-board.org/
data/economydatabase/.
Real GDP
per capita
(1990 dollars,
log scale)
$100,000
19
10
Real GDP per capita from 1900 to 2010,
measured in 1990 dollars, is shown
for the United States, India, and China.
Equal percent changes in real GDP per
capita are drawn the same size. As the
steeper slopes of the lines representing
China and India show, since 1980 India
and China had a much higher growth rate
than the United States. In 2000, China
attained the standard of living achieved in
the United States in 1900. In 2010, India
was still poorer than the United States
was in 1900. (The break in China data
from 1940 to 1950 is due to war.)
19
00
FIGURE 9-1
Year
CHAPTER 9
LONG-RUN ECONOMIC GROW TH
247
it produced 758% as much per person as it did in 1900, an almost eightfold
U.S. Real GDP
TABLE 9-1
increase. Alternatively, in 1900 the U.S. economy produced only 13% as
per Capita
much per person as it did in 2010.
Percentage of Percentage of
1900 real GDP 2010 real GDP
The income of the typical family normally grows more or less in proYear
per capita
per capita
portion to per capita income. For example, a 1% increase in real GDP per
capita corresponds, roughly, to a 1% increase in the income of the median
1900
100%
13%
or typical family—a family at the center of the income distribution. In 2010,
1920
136
18
the median American household had an income of about $50,000. Since
1940
171
23
Table 9-1 tells us that real GDP per capita in 1900 was only 13% of its 2010
1980
454
60
level, a typical family in 1900 probably had a purchasing power only 13%
2000
696
92
as large as the purchasing power of a typical family in 2010. That’s around
$6,850 in today’s dollars, representing a standard of living that we would
2010
758
100
now consider severe poverty. Today’s typical American family, if transportSources: Angus Maddison, Statistics on World
Population, GDP, and Per Capita GDP, 1–2008AD,
ed back to the United States of 1900, would feel quite a lot of deprivation.
“The First Update of the Madison Project:
Yet many people in the world have a standard of living equal to or lower
Reestimating Growth Before 1820” http://www.
ggdc.net/maddison; Bureau of Economic Analysis.
than that of the United States at the beginning of the last century. That’s the
message about China and India in Figure 9-1: despite dramatic economic
growth in China over the last three decades and the less dramatic acceleration
of economic growth in India, China has only recently exceeded the standard of
living that the United States enjoyed in the early twentieth century, while India is
still poorer than the United States was at that time. And much of the world today
is poorer than China or India.
FIGURE 9-2 Incomes
You can get a sense of how poor much of the world remains by looking at
Around
the World, 2013
Figure 9-2, a map of the world in which countries are classified according to their
Although the countries of Europe
2013 levels of GDP per capita, in U.S. dollars. As you can see, large parts of the
and North America—along with a few
world have very low incomes. Generally speaking, the countries of Europe and
in the Pacific—have high incomes,
North America, as well as a few in the Pacific, have high incomes. The rest of the
much of the world is still very poor.
world, containing most of its population, is dominated by countries with GDP
Today, about 50% of the world’s
less than $5,000 per capita—and often much less. In fact, today about 50% of the
population lives in countries with
world’s people live in countries with a lower standard of living than the United
a lower standard of living than the
States had a century ago.
United States had a century ago.
Source: International Monetary Fund.
NORTH
AMERICA
EUROPE
ASIA
AFRICA
SOUTH
AMERICA
AUSTRALIA
Low income ($1,045 or less)
Middle-low income,
greater than $1,046 ($1,046–5,000)
Middle-high income,
greater than $5,001 ($5,001–12,275)
High income ($12,276 or more)
Unavailable
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P I T FA L L S
CHANGE IN LEVELS VERSUS
RATE OF CHANGE
When studying economic growth, it’s
vitally important to understand the difference between a change in level and
a rate of change. When we say that real
GDP “grew,” we mean that the level of
real GDP increased. For example, we
might say that U.S. real GDP grew during 2013 by $297 billion.
If we knew the level of U.S. real GDP
in 2012, we could also represent the
amount of 2013 growth in terms of a
rate of change. For example, if U.S. real
GDP in 2012 had been $15,470 billion,
then U.S. real GDP in 2013 would have
been $15,470 billion + $297 billion =
$15,767 billion. We could calculate
the rate of change, or the growth
rate, of U.S. real GDP during 2013
as: (($15,767 billion − $15,470 billion)/
$15,470 billion) × 100 = $297 billion/
$15,470 billion) × 100 = 1.92%. Statements about economic growth over a
period of years almost always refer to
changes in the growth rate.
When talking about growth or growth
rates, economists often use phrases that
appear to mix the two concepts and so
can be confusing. For example, when
we say that “U.S. growth fell during the
1970s,” we are really saying that the U.S.
growth rate of real GDP was lower in the
1970s in comparison to the 1960s. When
we say that “growth accelerated during
the early 1990s,” we are saying that the
growth rate increased year after year in
the early 1990s—for example, going from
3% to 3.5% to 4%.
Growth Rates
How did the United States manage to produce over eight times as much per person in 2013 than in 1900? A little bit at a time. Long-run economic growth is normally a gradual process in which real GDP per capita grows at most a few percent
per year. From 1900 to 2013, real GDP per capita in the United States increased
an average of 1.9% each year.
To have a sense of the relationship between the annual growth rate of real
GDP per capita and the long-run change in real GDP per capita, it’s helpful to
keep in mind the Rule of 70, a mathematical formula that tells us how long it
takes real GDP per capita, or any other variable that grows gradually over time,
to double. The approximate answer is:
(9-1)
According to the Rule of 70, the
time it takes a variable that grows
gradually over time to double is
approximately 70 divided by that
variable’s annual growth rate.
Number of years for variable to double =
70
Annual growth rate of variable
(Note that the Rule of 70 can only be applied to a positive growth rate.) So if real
GDP per capita grows at 1% per year, it will take 70 years to double. If it grows at
2% per year, it will take only 35 years to double. In fact, U.S. real GDP per capita
rose on average 1.9% per year over the last century.
Applying the Rule of 70 to this information implies that it should have taken
37 years for real GDP per capita to double; it would have taken 111 years—three
periods of 37 years each—for U.S. real GDP per capita to double three times.
That is, the Rule of 70 implies that over the course of 111 years, U.S. real GDP per
capita should have increased by a factor of 2 × 2 × 2 = 8. And this does turn out
to be a pretty good approximation of reality. Between 1899 and 2010—a period of
111 years—real GDP per capita rose just about eightfold.
Figure 9-3 shows the average annual rate of growth of real GDP per capita for
selected countries from 1980 to 2013. Some countries were notable success stories: for example, China, though still quite poor, has made spectacular progress.
India, although not matching China’s performance, has also achieved impressive
growth, as discussed in the following Economics in Action.
Some countries, though, have had very disappointing growth. Argentina was
once considered a wealthy nation. In the early years of the twentieth century, it
was in the same league as the United States and Canada. But since then it has
lagged far behind more dynamic economies. And still others, like Zimbabwe,
have slid backward.
What explains these differences in growth rates? To answer that question, we
need to examine the sources of long-run economic growth.
CHAPTER 9
249
Comparing Recent Growth Rates
The average annual rate of
growth of real GDP per capita
from 1980 to 2013 is shown
here for selected countries.
China and, to a lesser extent,
India and Ireland achieved
impressive growth. The
United States and France
had moderate growth. Once
considered an economically
advanced country, Argentina
had more sluggish growth.
Still others, such as
Zimbabwe, slid backward.
Average annual
growth rate
of real GDP 10%
per capita,
1980–2013
8
6
4.3%
4
3.1%
1.7%
2
1.2%
.88%
0
–1.4%
–2
Source: The Conference Board Total
Economy Database™, January 2014,
http://www.conference-board.org/
data/economydatabase
China
in Action
India
Ireland
United
States
France
Argentina Zimbabwe
RLD VIE
O
W
s
ECONOMICS
7.6%
W
FIGURE 9-3
LONG-RUN ECONOMIC GROW TH
India Takes Off
Sipra Das/The India Today Group/Getty Images
I
ndia achieved independence from Great Britain in 1947, becoming the world’s
most populous democracy—a status it has maintained to this day. For more
than three decades after independence, however, this happy political story
was partly overshadowed by economic disappointment. Despite ambitious economic development plans, India’s performance was consistently sluggish. In 1980,
India’s real GDP per capita was only about 50% higher than it had been in 1947.
The gap between Indian living standards and those in wealthy countries like the
United States had been growing rather than shrinking.
Since then, however, India has done much better. As Figure 9-3 shows,
real GDP per capita has grown at an average rate of 4.3% a year, more than
tripling between 1980 and 2013. India now has a large and rapidly growing
middle class.
What went right in India after 1980? Many economists point to policy reforms. For decades after
independence, India had a tightly controlled, highly
regulated economy. Today, things are very different: a
series of reforms opened the economy to international
trade and freed up domestic competition. Some economists, however, argue that this can’t be the main story
because the big policy reforms weren’t adopted until
1991, yet growth accelerated around 1980.
Regardless of the explanation, India’s economic rise
has transformed it into a major new economic power—
and allowed hundreds of millions of people to have a
much better life, better than their grandparents could
have dreamed.
The big question now is whether this growth can
continue. Skeptics argue that there are important
India’s high rate of economic growth since 1980 has raised living stanbottlenecks in the Indian economy that may constrain
dards and led to the emergence of a rapidly growing middle class.
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Quick Review
• Economic growth is measured
using real GDP per capita.
• In the United States, real GDP
per capita increased eightfold
since 1900, resulting in a large
increase in living standards.
• Many countries have real GDP
per capita much lower than that
of the United States. More than
half of the world’s population has
living standards worse than those
existing in the United States in the
early 1900s.
• The long-term rise in real GDP
per capita is the result of gradual
growth. The Rule of 70 tells us
how many years at a given annual
rate of growth it takes to double
real GDP per capita.
future growth. They point in particular to the still low education level of much
of India’s population and inadequate infrastructure—that is, the poor quality and
limited capacity of the country’s roads, railroads, power supplies, and health
and sanitation infrastructure. Pollution is a severe and growing problem as well.
But India’s economy has defied the skeptics for several decades and the hope is
that it can continue doing so.
Check Your Understanding
9-1
1. Why do economists use real GDP per capita to measure economic progress rather
than some other measure, such as nominal GDP per capita or real GDP?
2. Apply the Rule of 70 to the data in Figure 9-3 to determine how long it will take
each of the countries listed there (except Zimbabwe) to double its real GDP per
capita. Would India’s real GDP per capita exceed that of the United States in the
future if growth rates remain as shown in Figure 9-3? Why or why not?
3. Although China and India currently have growth rates much higher than the U.S.
growth rate, the typical Chinese or Indian household is far poorer than the typical
American household. Explain why.
Solutions appear at back of book.
• Growth rates of real GDP per
capita differ substantially among
nations.
The Sources of Long-Run Growth
Long-run economic growth depends almost entirely on one ingredient: rising productivity. However, a number of factors affect the growth of productivity. Let’s look
first at why productivity is the key ingredient and then examine what affects it.
The Crucial Importance of Productivity
Labor productivity, often referred
to simply as productivity, is output
per worker.
Sustained economic growth occurs only when the amount of output produced by the
average worker increases steadily. The term labor productivity, or productivity
for short, is used to refer either to output per worker or, in some cases, to output
per hour. (The number of hours worked by an average worker differs to some
extent across countries, although this isn’t an important factor in the difference
between living standards in, say, India and the United States.) In this book we’ll
focus on output per worker. For the economy as a whole, productivity—output per
worker—is simply real GDP divided by the number of people working.
You might wonder why we say that higher productivity is the only source of
long-run growth. Can’t an economy also increase its real GDP per capita by putting more of the population to work? The answer is, yes, but . . . . For short periods
of time, an economy can experience a burst of growth in output per capita by putting a higher percentage of the population to work. That happened in the United
States during World War II, when millions of women who previously worked
only in the home entered the paid workforce. The percentage of adult civilians
employed outside the home rose from 50% in 1941 to 58% in 1944, and you can
see the resulting bump in real GDP per capita during those years in Figure 9-1.
Over the longer run, however, the rate of employment growth is never very
different from the rate of population growth. Over the course of the twentieth
century, for example, the population of the United States rose at an average rate of
1.3% per year and employment rose 1.5% per year. Real GDP per capita rose 1.9%
per year; of that, 1.7%—that is, almost 90% of the total—was the result of rising
productivity. In general, overall real GDP can grow because of population growth,
but any large increase in real GDP per capita must be the result of increased output per worker. That is, it must be due to higher productivity.
So increased productivity is the key to long-run economic growth. But what
leads to higher productivity?
CHAPTER 9
LONG-RUN ECONOMIC GROW TH
Explaining Growth in Productivity
There are three main reasons why the average U.S. worker today produces far
more than his or her counterpart a century ago. First, the modern worker has far
more physical capital, such as machinery and office space, to work with. Second,
the modern worker is much better educated and so possesses much more human
capital. Finally, modern firms have the advantage of a century’s accumulation of
technical advancements reflecting a great deal of technological progress.
Let’s look at each of these factors in turn.
Increase in Physical Capital Economists define physical capital as manufactured resources such as buildings and machines. Physical capital makes workers
more productive. For example, a worker operating a backhoe can dig a lot more
feet of trench per day than one equipped only with a shovel.
The average U.S. private-sector worker today is backed up by more than
$150,000 worth of physical capital—far more than a U.S. worker had 100 years
ago and far more than the average worker in most other countries has today.
Increase in Human Capital It’s not enough for a worker to have good equipment—
he or she must also know what to do with it. Human capital refers to the improvement in labor created by the education and knowledge embodied in the workforce.
The human capital of the United States has increased dramatically over the
past century. A century ago, although most Americans were able to read and
write, very few had an extensive education. In 1910, only 13.5% of Americans
over 25 had graduated from high school and only 3% had four-year college
degrees. By 2010, the percentages were 87% and 30%, respectively. It would be
impossible to run today’s economy with a population as poorly educated as that
of a century ago.
Analyses based on growth accounting, described later in this chapter, suggest
that education—and its effect on productivity—is an even more important determinant of growth than increases in physical capital.
Technological Progress Probably the most important driver of productivity
growth is technological progress, which is broadly defined as an advance in the
technical means of the production of goods and services. We’ll see shortly how
economists measure the impact of technology on growth.
Workers today are able to produce more than those in the past, even with the
same amount of physical and human capital, because technology has advanced
over time. It’s important to realize that economically important technological
progress need not be flashy or rely on cutting-edge science. Historians have noted
that past economic growth has been driven not only by major inventions, such as
the railroad or the semiconductor chip, but also by thousands of modest innovations, such as the flat-bottomed paper bag, patented in 1870, which made packing
groceries and many other goods much easier, and the Post-it® note, introduced
in 1981, which has had surprisingly large benefits for office productivity. Experts
attribute much of the productivity surge that took place in the United States late in
the twentieth century to new technology adopted by service-producing companies
like Walmart rather than to high-technology companies.
Accounting for Growth:
The Aggregate Production Function
Productivity is higher, other things equal, when workers are equipped with more
physical capital, more human capital, better technology, or any combination of
the three. But can we put numbers to these effects? To do this, economists make
use of estimates of the aggregate production function, which shows how productivity depends on the quantities of physical capital per worker and human
capital per worker as well as the state of technology.
251
Physical capital consists of
human-made resources such as
buildings and machines.
Human capital is the improvement
in labor created by the education
and knowledge embodied in the
workforce.
Technological progress is an
advance in the technical means
of the production of goods and
services.
The aggregate production
function is a hypothetical function
that shows how productivity (real
GDP per worker) depends on the
quantities of physical capital per
worker and human capital per worker
as well as the state of technology.
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An aggregate production function
exhibits diminishing returns to
physical capital when, holding
the amount of human capital per
worker and the state of technology
fixed, each successive increase in
the amount of physical capital per
worker leads to a smaller increase in
productivity.
In general, all three factors tend to rise over time, as workers are equipped
with more machinery, receive more education, and benefit from technological
advances. What the aggregate production function does is allow economists to
disentangle the effects of these three factors on overall productivity.
An example of an aggregate production function applied to real data comes
from a comparative study of Chinese and Indian economic growth by the economists Barry Bosworth and Susan Collins of the Brookings Institution. They used
the following aggregate production function:
GDP per worker = T × (Physical capital per worker)0.4 × (Human capital per worker)0.6
where T represented an estimate of the level of technology and they assumed
that each year of education raises workers’ human capital by 7%. Using this
function, they tried to explain why China grew faster than India between 1978
and 2004. About half the difference, they found, was due to China’s higher levels
of investment spending, which raised its level of physical capital per worker faster than India’s. The other half was due to faster Chinese technological progress.
In analyzing historical economic growth, economists have discovered a
crucial fact about the estimated aggregate production function: it exhibits
diminishing returns to physical capital. That is, when the amount of human
capital per worker and the state of technology are held fixed, each successive
increase in the amount of physical capital per worker leads to a smaller increase
in productivity.
Figure 9-4 and the table to its right give a hypothetical example of how the
level of physical capital per worker might affect the level of real GDP per worker,
holding human capital per worker and the state of technology fixed. In this
example, we measure the quantity of physical capital in dollars.
FIGURE 9-4
Physical Capital and Productivity
Real GDP
per worker
Productivity
1. The increase $60,000
in real GDP
50,000
per worker
becomes
smaller . . .
30,000
0
C
B
Physical
capital
per worker
Real GDP
per worker
$ 0
20,000
40,000
60,000
$ 0
30,000
50,000
60,000
A
$20,000
40,000
60,000
2. . . . as physical capital per worker
rises by equal size increments.
The aggregate production function shows how, in this case,
holding human capital per worker and technology fixed,
productivity increases as physical capital per worker rises. Other
things equal, a greater quantity of physical capital per worker
leads to higher real GDP per worker but is subject to diminishing
returns: each successive addition to physical capital per worker
produces a smaller increase in productivity. Starting at the origin,
Physical
capital per
worker
0, a $20,000 increase in physical capital per worker leads to an
increase in real GDP per worker of $30,000, indicated by
point A. Starting from point A, another $20,000 increase in
physical capital per worker leads to an increase in real GDP per
worker but only of $20,000, indicated by point B. Finally, a third
$20,000 increase in physical capital per worker leads to only a
$10,000 increase in real GDP per worker, indicated by point C.
CHAPTER 9
LONG-RUN ECONOMIC GROW TH
253
To see why the relationship between physical capital per worker and productivity exhibits diminishing returns, think about how having farm equipment affects
the productivity of farmworkers. A little bit of equipment makes a big difference:
a worker equipped with a tractor can do much more than a worker without one.
And a worker using more expensive equipment will, other things equal, be more
productive: a worker with a $40,000 tractor will normally be able to cultivate more
farmland in a given amount of time than a worker with a $20,000 tractor because
the more expensive machine will be more powerful, perform more tasks, or both.
But will a worker with a $40,000 tractor, holding human capital and technology constant, be twice as productive as a worker with a $20,000 tractor? Probably
not: there’s a huge difference between not having a tractor at all and having even
an inexpensive tractor; there’s much less difference between having an inexpensive tractor and having a better tractor. And we can be sure that a worker with a
$200,000 tractor won’t be 10 times as productive: a tractor can be improved only
so much. Because the same is true of other kinds of equipment, the aggregate
production function shows diminishing returns to physical capital.
Diminishing returns to physical capital imply a relationship between physical
capital per worker and output per worker like the one shown in Figure 9-4. As
the productivity curve for physical capital and the accompanying table illustrate,
more physical capital per worker leads to more output per worker. But each
$20,000 increment in physical capital per worker adds less to productivity.
As you can see from the table, there is a big payoff for the first $20,000 of physical capital: real GDP per worker rises by $30,000. The second $20,000 of physical
capital also raises productivity, but not by as much: real GDP per worker goes up
by only $20,000. The third $20,000 of physical capital raises real GDP per worker
by only $10,000. By comparing points along the curve you can also see that as
physical capital per worker rises, output per worker also rises—but at a diminishing rate. Going from the origin at 0 to point A, a $20,000 increase in physical
capital per worker, leads to an increase of $30,000 in real GDP per worker. Going
from point A to point B, a second $20,000 increase in physical capital per worker,
leads to an increase of only $20,000 in real GDP per worker. And from point B to
point C, a $20,000 increase in physical capital per worker, increased real GDP per
worker by only $10,000.
It’s important to realize that diminishing returns to physical capital is an
“other things equal” phenomenon: additional amounts of physical capital are
less productive when the amount of human capital per worker and the technology
are held fixed. Diminishing returns may disappear if we increase the amount of
human capital per worker, or improve the technology, or both at the same time
the amount of physical capital per worker is increased.
For example, a worker with a $40,000 tractor who has also been trained in the
most advanced cultivation techniques may in fact be more than twice as productive as a worker with only a $20,000 tractor and no additional human capital. But
diminishing returns to any one input—regardless of whether it is physical capital,
human capital, or number of workers—is a pervasive characteristic of production.
Typical estimates suggest that in practice a 1% increase in the quantity of physical
capital per worker increases output per worker by only one-third of 1%, or 0.33%.
In practice, all the factors contributing to higher productivity rise during the
course of economic growth: both physical capital and human capital per worker
increase, and technology advances as well. To disentangle the effects of these
factors, economists use growth accounting, which estimates the contribution of
each major factor in the aggregate production function to economic growth. For
example, suppose the following are true:
• The amount of physical capital per worker grows 3% per year.
• According to estimates of the aggregate production function, each 1% rise in
physical capital per worker, holding human capital and technology constant,
raises output per worker by one-third of 1%, or 0.33%.
Growth accounting estimates the
contribution of each major factor in
the aggregate production function to
economic growth.
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P I T FA L L S
IT MAY BE DIMINISHED . . . BUT IT’S
STILL POSITIVE
It’s important to understand what diminishing returns to physical capital means
and what it doesn’t mean. As we’ve
already explained, it’s an “other things
equal” statement: holding the amount
of human capital per worker and the
technology fixed, each successive
increase in the amount of physical
capital per worker results in a smaller
increase in real GDP per worker. But
this doesn’t mean that real GDP per
worker eventually falls as more and
more physical capital is added. It’s
just that the increase in real GDP per
worker gets smaller and smaller, albeit
remaining at or above zero. So an
increase in physical capital per worker
will never reduce productivity. But due
to diminishing returns, at some point
increasing the amount of physical
capital per worker no longer produces
an economic payoff: at some point the
increase in output is so small that it
is not worth the cost of the additional
physical capital.
In that case, we would estimate that growing physical capital per worker is
responsible for 3% × 0.33 = 1 percentage point of productivity growth per year.
A similar but more complex procedure is used to estimate the effects of growing
human capital. The procedure is more complex because there aren’t simple dollar
measures of the quantity of human capital.
Growth accounting allows us to calculate the effects of greater physical and
human capital on economic growth. But how can we estimate the effects of
technological progress? We do so by estimating what is left over after the effects
of physical and human capital have been taken into account. For example, let’s
imagine that there was no increase in human capital per worker so that we can
focus on changes in physical capital and in technology.
In Figure 9-5, the lower curve shows the same hypothetical relationship
between physical capital per worker and output per worker shown in Figure 9-4.
Let’s assume that this was the relationship given the technology available in 1940.
FIGURE 9-5
Technological Progress and Productivity Growth
Technological progress raises
productivity at any given level of physical
capital per worker, and therefore shifts
the aggregate production function
upward. Here we hold human capital
per worker fixed. We assume that the
lower curve (the same curve as in
Figure 9-4) reflects technology in 1940
and the upper curve reflects technology
in 2010. Holding technology and human
capital fixed, tripling physical capital
per worker from $20,000 to $60,000
leads to a doubling of real GDP per
worker, from $30,000 to $60,000. This
is shown by the movement from point A
to point C, reflecting an approximately
1% per year rise in real GDP per
worker. In reality, technological progress
raised productivity at any given level
of physical capital—shown here by
the upward shift of the curve—and the
actual rise in real GDP per worker is
shown by the movement from point A to
point D. Real GDP per worker grew 2%
per year, leading to a quadrupling during
the period. The extra 1% in growth of
real GDP per worker is due to higher
total factor productivity.
Real GDP
per worker
(constant dollars)
Productivity
using 2010
technology
$120,000
D
90,000
Rising total factor
productivity shifts
curve up
60,000
30,000
0
C
Productivity
using 1940
technology
A
$20,000
40,000
60,000
80,000
Physical capital per worker
(constant dollars)
CHAPTER 9
LONG-RUN ECONOMIC GROW TH
The upper curve also shows a relationship between physical capital per worker
and productivity, but this time given the technology available in 2010. (We’ve chosen a 70-year stretch to allow us to use the Rule of 70.) The 2010 curve is shifted
up compared to the 1940 curve because technologies developed over the previous
70 years make it possible to produce more output for a given amount of physical
capital per worker than was possible with the technology available in 1940. (Note
that the two curves are measured in constant dollars.)
Let’s assume that between 1940 and 2010 the amount of physical capital per
worker rose from $20,000 to $60,000. If this increase in physical capital per worker had taken place without any technological progress, the economy would have
moved from A to C: output per worker would have risen, but only from $30,000
to $60,000, or 1% per year (using the Rule of 70 tells us that a 1% growth rate
over 70 years doubles output). In fact, however, the economy moved from A to D:
output rose from $30,000 to $120,000, or 2% per year. There was an increase in
both physical capital per worker and technological progress, which shifted the
aggregate production function.
In this case, 50% of the annual 2% increase in productivity—that is, 1% in
annual productivity growth—is due to higher total factor productivity, the
amount of output that can be produced with a given amount of factor inputs. So
when total factor productivity increases, the economy can produce more output
with the same quantity of physical capital, human capital, and labor.
Most estimates find that increases in total factor productivity are central to
a country’s economic growth. We believe that observed increases in total factor
productivity in fact measure the economic effects of technological progress. All of
this implies that technological change is crucial to economic growth.
The Bureau of Labor Statistics estimates the growth rate of both labor productivity and total factor productivity for nonfarm business in the United States.
According to the Bureau’s estimates, over the period from 1948 to 2010 American
labor productivity rose 2.3% per year. Only 49% of that rise is explained by
increases in physical and human capital per worker; the rest is explained by rising total factor productivity—that is, by technological progress.
What About Natural Resources?
In our discussion so far, we haven’t mentioned natural resources, which certainly
have an effect on productivity. Other things equal, countries that are abundant
in valuable natural resources, such as highly fertile land or rich mineral deposits,
have higher real GDP per capita than less fortunate countries. The most obvious
modern example is the Middle East, where enormous oil deposits have made a
few sparsely populated countries very rich. For example, Kuwait has about the
same level of real GDP per capita as Germany, but Kuwait’s wealth is based on oil,
not manufacturing, the source of Germany’s high output per worker.
But other things are often not equal. In the modern world, natural resources are
a much less important determinant of productivity than human or physical capital
for the great majority of countries. For example, some nations with very high real
GDP per capita, such as Japan, have very few natural resources. Some resourcerich nations, such as Nigeria (which has sizable oil deposits), are very poor.
Historically, natural resources played a much more prominent role in determining productivity. In the nineteenth century, the countries with the highest
real GDP per capita were those abundant in rich farmland and mineral deposits:
the United States, Canada, Argentina, and Australia. As a consequence, natural
resources figured prominently in the development of economic thought.
In a famous book published in 1798, An Essay on the Principle of Population,
the English economist Thomas Malthus made the fixed quantity of land in the
world the basis of a pessimistic prediction about future productivity. As population grew, he pointed out, the amount of land per worker would decline. And this,
other things equal, would cause productivity to fall.
255
Total factor productivity is
the amount of output that can be
achieved with a given amount of
factor inputs.
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in Action
RLD VIE
O
W
s
ECONOMICS
W
His view, in fact, was that improvements in technology or increases in physical
capital would lead only to temporary improvements in productivity because they
would always be offset by the pressure of rising population and more workers
on the supply of land. In the long run, he concluded, the great majority of people
were condemned to living on the edge of starvation. Only then would death rates
be high enough and birth rates low enough to prevent rapid population growth
from outstripping productivity growth.
It hasn’t turned out that way, although many historians believe that
Malthus’s prediction of falling or stagnant productivity was valid for much of
human history. Population pressure probably did prevent large productivity
increases until the eighteenth century. But in the time since Malthus wrote his
book, any negative effects on productivity from population growth have been
far outweighed by other, positive factors—advances in technology, increases in
human and physical capital, and the opening up of enormous amounts of cultivable land in the New World.
It remains true, however, that we live on a finite planet, with limited supplies
of resources such as oil and limited ability to absorb environmental damage. We
address the concerns these limitations pose for economic growth in the final section of this chapter.
Is the End of Economic Growth in Sight?
I
n 2012 Robert Gordon of Northwestern University, an influential macroeconomist and economic historian, created a stir with a paper suggesting
that the best days of long-run economic growth are behind us. Technological
innovation continues, of course. But Gordon made the case that the payoff from
recent innovations will be limited, especially compared with the great innovations of the past.
Gordon made his case, in part, by contrasting recent innovations—which
have mainly centered around information technology, from computers and
smartphones to the internet—with the great innovations that took place in the
late-nineteenth century. He argued that these late-nineteenth-century innovations, often described as the “Second Industrial Revolution,” continued to drive
growth for most of the twentieth century.
According to Gordon, there were five big
Is the End of Economic Growth Near? A Look
innovations:
at Growth of Real GDP per Capita, 1300–2100
FIGURE 9-6
1. Electricity
Growth rate
(percent)
2. The internal combustion engine
3.0%
U.S. actual
growth rate
Gordon’s
hypothetical path
for growth
2.5
telephones
U.K. actual
growth rate
1.5
1.0
00
21
00
20
00
19
00
18
17
00
0
16
0
00
15
14
00
0.5
00
4. Modern chemistry
5. M
ass communication, movies, and
2.0
13
3. Running water and central heating
Year
Source: Data from Robert J. Gordon.
How does the information technology
revolution stack up against these changes?
In Gordon’s account, it’s less important than
any one of the five. As he likes to put it,
which would you rather give up—the internet, or indoor plumbing?
Gordon also argues that the numbers bear
him out. Figure 9-6 illustrates his argument.
The blue and red lines show the historical
rate of growth of real GDP per capita in the
CHAPTER 9
LONG-RUN ECONOMIC GROW TH
world’s “technological leaders”—Britain (red) before 1906, the United States (blue)
thereafter. The green line shows a “smoothed” version of this history, which Gordon
sees as a huge but temporary hump, and then extrapolates this pattern forward. As
he says, growth rates got higher and higher until around the 1950s, but have fallen
since then—and he argues that they will keep on falling, and that growth will eventually come to a virtual halt.
Is Gordon right? The most persuasive counterargument says that we have only
just begun to see the payoff of modern technologies. As a recent book by MIT’s
Eric Brynjolfsson and Andrew McAfee, Race Against the Machine, points out, in
the past few years innovative technologies addressing a number of seemingly
intractable problems have reached the state where they’re either already on the
market or ready to go—these include useful speech recognition, machine translation, self-driving vehicles, and more. So you can make the case that we are on the
cusp of truly transformative technological change right now.
Who’s right? As Yogi Berra said, “It's tough to make predictions, especially about
the future.” What’s clear, however, is that both sides are asking the right question,
because technology is, ultimately, the main driver of long-run economic growth.
Check Your Understanding
9-2
1. Predict the effect of each of the following events on the growth rate of productivity.
a. The amounts of physical and human capital per worker are unchanged, but
there is significant technological progress.
b. The amount of physical capital per worker grows at a steady pace, but the level
of human capital per worker and technology are unchanged.
2. Output in the economy of Erewhon has grown 3% per year over the past 30 years.
The labor force has grown at 1% per year, and the quantity of physical capital has
grown at 4% per year. The average education level hasn’t changed. Estimates by
economists say that each 1% increase in physical capital per worker, other things
equal, raises productivity by 0.3%. (Hint: % change in (X/Y) = % change in X − %
change in Y.)
a. How fast has productivity in Erewhon grown?
b. How fast has physical capital per worker grown?
c. How much has growing physical capital per worker contributed to productivity
growth? What percentage of productivity growth is that?
d. How much has technological progress contributed to productivity growth?
What percentage of productivity growth is that?
3. Multinomics, Inc., is a large company with many offices around the country. It
has just adopted a new computer system that will affect virtually every function
performed within the company. Why might a period of time pass before employees’ productivity is improved by the new computer system? Why might there be a
temporary decrease in employees’ productivity?
Solutions appear at back of book.
Why Growth Rates Differ
In 1820, according to estimates by the economic historian Angus Maddison,
Mexico had somewhat higher real GDP per capita than Japan. Today, Japan has
higher real GDP per capita than most European nations and Mexico is a poor
country, though by no means among the poorest. The difference? Over the long
run—since 1820—real GDP per capita grew at 1.9% per year in Japan but at only
1.3% per year in Mexico.
As this example illustrates, even small differences in growth rates have large
consequences over the long run. So why do growth rates differ across countries
and across periods of time?
257
Quick Review
• Long-run increases in living
standards arise almost entirely
from growing labor productivity,
often simply referred to as
productivity.
• An increase in physical
capital is one source of higher
productivity, but it is subject to
diminishing returns to physical
capital.
• Human capital and
technological progress are
also sources of increases in
productivity.
• The aggregate production
function is used to estimate
the sources of increases in
productivity. Growth accounting
has shown that rising total factor
productivity, interpreted as the
effect of technological progress,
is central to long-run economic
growth.
• Natural resources are less
important today than physical
and human capital as sources
of productivity growth in most
economies.
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Explaining Differences in Growth Rates
As one might expect, economies with rapid growth tend to be economies that add
physical capital, increase their human capital, or experience rapid technological
progress. Striking economic success stories, like Japan in the 1950s and 1960s or
China today, tend to be countries that do all three: rapidly add to their physical
capital through high savings and investment spending, upgrade their educational
level, and make fast technological progress. Evidence also points to the importance of government policies, property rights, political stability, and good governance in fostering the sources of growth.
Savings and Investment Spending One reason for differences in growth rates
between countries is that some countries are increasing their stock of physical
capital much more rapidly than others, through high rates of investment spending. In the 1960s, Japan was the fastest-growing major economy; it also spent a
much higher share of its GDP on investment goods than did other major economies. Today, China is the fastest-growing major economy, and it similarly spends
a very large share of its GDP on investment goods. In 2014, investment spending
was 48% of China’s GDP, compared with only 20% in the United States.
Where does the money for high investment spending come from? From savings. In the next chapter we’ll analyze how financial markets channel savings into
investment spending. For now, however, the key point is that investment spending
must be paid for either out of savings from domestic households or by savings
from foreign households—that is, an inflow of foreign capital.
Foreign capital has played an important role in the long-run economic growth
of some countries, including the United States, which relied heavily on foreign
funds during its early industrialization. For the most part, however, countries
that invest a large share of their GDP are able to do so because they have high
domestic savings. In fact, China in 2014 saved an even higher percentage of its
GDP than it invested at home. The extra savings were invested abroad, largely in
the United States.
One reason for differences in growth rates, then, is that countries add different amounts to their stocks of physical capital because they have different rates
of savings and investment spending.
Education Just as countries differ substantially in the rate at which they add
to their physical capital, there have been large differences in the rate at which
countries add to their human capital through education.
A case in point is the comparison between Argentina and China. In both countries the average educational level has risen steadily over time, but it has risen
much faster in China. Figure 9-7 shows the average years of education of adults in
China, which we have highlighted as a spectacular example of long-run growth,
and in Argentina, a country whose growth has been disappointing. Compared to
China, sixty years ago, Argentina had a much more educated population, while
many Chinese were still illiterate. Today, the average educational level in China
is still slightly below that in Argentina—but that’s mainly because there are still
many elderly adults who never received basic education. In terms of secondary
and tertiary education, China has outstripped once-rich Argentina.
Research and Development The advance of technology is a key force behind
economic growth. What drives technological progress?
Scientific advances make new technologies possible. To take the most spectacular example in today’s world, the semiconductor chip—which is the basis for
all modern information technology—could not have been developed without the
theory of quantum mechanics in physics.
But science alone is not enough: scientific knowledge must be translated into
useful products and processes. And that often requires devoting a lot of resources
CHAPTER 9
FIGURE 9-7
259
LONG-RUN ECONOMIC GROW TH
China’s Students Are Catching Up
In both China and Argentina, the average
educational level—measured by the number
of years the average adult aged 25 or
older has spent in school—has risen over
time. Although China is still lagging behind
Argentina, it is catching up—and China’s
success at adding human capital is one key
to its spectacular long-run growth.
Source: Robert Barro and Jong-Wha Lee, “A New
Data Set of Educational Attainment in the World,
1950–2010,” NBER Working Paper No. 15902
(April 2010), http://www.barrolee.com.
Years of
schooling
Argentina
10
9.3
7.9
8
China
7.5
5.9
6
4.9
4.6
4
2.5
2
0.7
1950
1970
1990
2010
Year
to research and development, or R&D, spending to create new technologies and
apply them to practical use.
Although some research and development is conducted by governments, much
R&D is paid for by the private sector, as discussed below. The United States
became the world’s leading economy in large part because American businesses
were among the first to make systematic research and development a part of their
operations. The upcoming For Inquiring Minds describes how Thomas Edison
created the first modern industrial research laboratory.
Developing new technology is one thing; applying it is another. There have often
been notable differences in the pace at which different countries take advantage of
new technologies. For example, as the following Global Comparison shows, since
2000, Italy has suffered a significant decline in its total factor productivity, while
the United States and Germany have powered ahead. The sources of these national
differences are the subject of a great deal of economic research.
Thomas Edison is best known as
the inventor of the lightbulb and
the phonograph. But his biggest
invention may surprise you: he
invented research and development.
Before Edison’s time, there had,
of course, been many inventors.
Some of them worked in teams. But
in 1875 Edison created something
new: his Menlo Park, New Jersey,
laboratory. It employed 25 men full
time to generate new products and
processes for business. In other
words, he did not set out to pursue
a particular idea and then cash in.
He created an organization whose
purpose was to create new ideas
year after year.
Edison’s Menlo Park lab is now
a museum. “To name a few of
Inventing R&D
Dennis MacDonald/Alamy
FOR INQUIRING MINDS
Research and development, or
R&D, is spending to create and
implement new technologies.
Edison in his lab in 1888 with a work in progress:
the phonograph.
the products that were developed
in Menlo Park,” says the museum’s
website, “we can list the following:
the carbon button mouthpiece for
the telephone, the phonograph, the
incandescent lightbulb and the electrical distribution system, the electric
train, ore separation, the Edison effect
bulb, early experiments in wireless, the
grasshopper telegraph, and improvements in telegraphic transmission.”
You could say that before Edison’s
lab, technology just sort of happened:
people came up with ideas, but
businesses didn’t plan to make
continuous technological progress.
Now R&D operations, often much
bigger than Edison’s original team,
are standard practice throughout the
business world.
•
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GLOBAL
COMPARISION
What’s the Matter with Italy?
I
13
20
11
20
09
20
07
20
05
20
03
20
20
01
n the preceding Economics in Action, we described the
from taking advantage of the opportunities new technology
ongoing debate over the state of technological progress.
has to offer.
Will information technology lead to sustained growth, or is it
It’s a troubling picture, and one that surely should be
already past its prime? Nobody really knows. One thing does
addressed with a variety of economic reforms. Unfortunately,
seem clear, however: some countries have been much more
Italy’s troubles aren’t just economic: it also suffers from
successful at making use of new technologies than others.
chronic political weakness, which has left successive govIn the early stages of the information technology, or IT,
ernments with little ability to take strong action on any front.
revolution, it seemed that the United States was
pulling ahead of Europe. That’s less clear now:
Total factor
some European countries have moved forward
productivity,
rapidly in broadband, the wireless internet, and
2000 = 100
more. But one major European nation is clearly
Germany
110
lagging on all fronts: Italy.
The accompanying figure shows estimates of
105
total factor productivity growth since 2000 in three
countries: the United States, Germany (Europe’s
100
United States
largest economy), and Italy. The United States and
95
Germany have been roughly keeping pace. But
Italy seems, remarkably, to have actually been slipItaly
90
ping backwards.
This may be, in part, a consequence of the continuing economic slump in Europe. But researchers studying Italian business argue that a variety
of institutional factors, ranging from rigid labor
Year
markets to poor management, have prevented Italy
Source: The Conference Board Total Economy Database™, January 2014, http://www.conference-board.org/data/economydatabase/.
The Role of Government in Promoting Economic Growth
Governments can play an important role in promoting—or blocking—all three sources of long-term economic growth: physical capital, human capital, and technological
progress. They can either affect growth directly through subsidies to factors that
enhance growth, or by creating an environment that either fosters or hinders growth.
Government Policies Government policies can increase the economy’s growth
rate through four main channels.
Roads, power lines, ports,
information networks, and other
underpinnings for economic activity
are known as infrastructure.
1. GOVERNMENT SUBSIDIES TO INFRASTRUCTURE Governments play an
important direct role in building infrastructure: roads, power lines, ports, information networks, and other large-scale physical capital projects that provide a
foundation for economic activity. Although some infrastructure is provided by
private companies, much of it is either provided by the government or requires
a great deal of government regulation and support. Ireland is often cited as an
example of the importance of government-provided infrastructure. After the government invested in an excellent telecommunications infrastructure in the 1980s,
Ireland became a favored location for high-technology companies from abroad
and its economy took off in the 1990s.
Poor infrastructure, such as a power grid that frequently fails and cuts off
electricity, is a major obstacle to economic growth in many countries. To provide
good infrastructure, an economy must not only be able to afford it, but it must
also have the political discipline to maintain it.
Perhaps the most crucial infrastructure is something we, in an advanced
country, rarely think about: basic public health measures in the form of a clean
CHAPTER 9
LONG-RUN ECONOMIC GROW TH
261
water supply and disease control. As we’ll see in the next section, poor health
infrastructure is a major obstacle to economic growth in poor countries, especially those in Africa.
2. GOVERNMENT SUBSIDIES TO EDUCATION In contrast to physical capital,
which is mainly created by private investment spending, much of an economy’s
human capital is the result of government spending on education. Government
pays for the great bulk of primary and secondary education. And it pays for a
significant share of higher education: 75% of students attend public colleges
and universities, and government significantly subsidizes research performed
at private colleges and universities. As a result, differences in the rate at which
countries add to their human capital largely reflect government policy. As we saw
in Figure 9-7, educational levels in China are increasing much more rapidly than
in Argentina. This isn’t because China is richer than Argentina; until recently,
China was, on average, poorer than Argentina. Instead, it reflects the fact that
the Chinese government has made education of the population a high priority.
3. GOVERNMENT SUBSIDIES TO R&D Technological progress is largely the result
of private initiative. But in the more advanced countries, important R&D is done
by government agencies as well. For example, the internet grew out of a system,
the Advanced Research Projects Agency Network (ARPANET), created by the U.S.
Defense department, then extended to educational institutions by the National
Science Foundation.
4. MAINTAINING A WELL-FUNCTIONING FINANCIAL SYSTEM Governments play
an important indirect role in making high rates of private investment spending
possible. Both the amount of savings and the ability of an economy to direct
savings into productive investment spending depend on the economy’s institutions, especially its financial system. In particular, a well-regulated and wellfunctioning financial system is very important for economic growth because
in most countries it is the principal way in which savings are channeled into
investment spending.
If a country’s citizens trust their banks, they will place their savings in bank
deposits, which the banks will then lend to their business customers. But if people
don’t trust their banks, they will hoard gold or foreign currency, keeping their
FOR INQUIRING MINDS
Until the 1990s, economic models of
technological progress assumed that
what drove innovation was a mystery—
unknown and unpredictable. In the words
of economists, the sources of technological progress were exogenous—they
were outside the models of economics
and assumed to “just happen.” Then, in a
series of influential papers written in the
1980s and 1990s, Paul Romer founded
what we now call “the New Growth
Theory.” In Romer’s model, technological progress was explainable because it
was in fact endogenous—the outcome of
economic variables and incentives. And
because technological progress was
endogenous, policies could be adopted
to foster its growth.
At any point in time, an economy
has a stock of knowledge capital—the
The New Growth Theory
accumulated knowledge generated by
past investments in research and development, education, and skill enhancement, as well as knowledge acquired
from other economies. And that stock of
knowledge capital is spread throughout
the economy, so all firms benefit from it.
According to the New Growth Theory, a
rising stock of knowledge capital creates
the foundation for further technological
progress as innovation, shared by firms
throughout the economy, makes further
innovation possible. For example, touchscreen technology—developed in the
1970s and 1980s—became the basis
for later developments such as smartphones and tablets.
Yet, as Romer pointed out, there is
a severe wrinkle in this story: because
knowledge is shared throughout the
economy, it may be very difficult for
an innovator to capture the rewards of
his or her innovation as others exploit
the innovation for their own interests. So in the New Growth Theory,
government protection of intellectual
property rights is critical to furthering
technological progress. In addition,
governments, institutions, and firms
can enhance technological progress
by subsidizing investments in education and research and development,
which, in turn, can increase the stock
of knowledge capital.
By giving us a better model of where
technological progress comes from,
the New Growth Theory makes clear
how important the policies of government, institutions, and firms are in fostering it.
•
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LONG-RUN ECONOMIC GROW TH
savings in safe deposit boxes or under the mattress, where it cannot be turned
into productive investment spending. As we’ll discuss later, a well-functioning
financial system requires appropriate government regulation to assure depositors
that their funds are protected from loss.
Protection of Property Rights Property rights are the rights of owners of valuable items to dispose of those items as they choose. A subset, intellectual property
rights, are the rights of an innovator to accrue the rewards of her innovation. The
state of property rights generally, and intellectual property rights in particular, are
important factors in explaining differences in growth rates across economies. Why?
Because no one would bother to spend the effort and resources required to innovate
if someone else could appropriate that innovation and capture the rewards. So, for
innovation to flourish, intellectual property rights must receive protection.
Sometimes this is accomplished by the nature of the innovation: it may be too
difficult or expensive to copy. But, generally, the government has to protect intellectual property rights. A patent is a government-created temporary monopoly
given to an innovator for the use or sale of his or her innovation. It’s a temporary
rather than permanent monopoly because while it’s in society’s interests to give
an innovator an incentive to invent, it’s also in society’s interests to eventually
encourage competition.
Political Stability and Good Governance There’s not much point in investing
in a business if rioting mobs are likely to destroy it, or in saving your money if
someone with political connections can steal it. Political stability and good governance (including the protection of property rights) are essential ingredients in
fostering economic growth in the long run.
Long-run economic growth in successful economies, like that of the United
States, has been possible because there are good laws, institutions that enforce
those laws, and a stable political system that maintains those institutions. The
law must say that your property is really yours so that someone else can’t take
it away. The courts and the police must be honest so that they can’t be bribed to
ignore the law. And the political system must be stable so that laws don’t change
capriciously.
Americans take these preconditions for granted, but they are by no means
guaranteed. Aside from the disruption caused by war or revolution, many
countries find that their economic growth suffers due to corruption among the
government officials who should be enforcing the law. For example, until 1991
the Indian government imposed many bureaucratic restrictions on businesses,
which often had to bribe government officials to get approval for even routine
activities—a tax on business, in effect. Economists have argued that a reduction
in this burden of corruption is one reason Indian growth has been much faster
in recent years.
Even when the government isn’t corrupt, excessive government intervention can
be a brake on economic growth. If large parts of the economy are supported by
government subsidies, protected from imports, subject to unnecessary monopolization, or otherwise insulated from competition, productivity tends to suffer because
of a lack of incentives. As we’ll see in the next section, excessive government intervention is one often-cited explanation for slow growth in Latin America.
in Action
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Why Did Britain Fall Behind?
I
t’s one of the classic questions in economic history: Why did Britain, the home
of the Industrial Revolution, by far the world’s leading economy for much of
the nineteenth century, end up falling behind other nations at the start of a
new century? It’s not a tragic story: the British economy continued to grow, and
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it remained a rich country by international standards.
Still, by the early twentieth century it was obvious
that British industry was no longer at the cutting edge.
Instead, the United States and Germany had come to
supplant Britain as the new economic frontier. What
happened?
That’s not an easy question to answer. Robert Solow,
an MIT economics professor and Nobel laureate who pioneered the theory of economic growth, once memorably
declared that all efforts to explain Britain’s lag end in “a
blaze of amateur sociology.” Indeed, among the reasons
often given for the lag are such things as the excessive
influence of the landed aristocracy, social barriers that
prevented talented individuals from the wrong class
from rising, and a cult of amateurism that was good
enough for people running small family firms but not for
Now catching up, Britain fell behind the United States and
the managers of large modern corporations.
Germany largely due to barriers to education.
There were, however, other factors in Britain’s relative decline that were more easily measured. Of special importance was education. Britain was much slower than other industrial countries, the United States
in particular, to establish universal basic education. Moreover, its universities,
for all their ancient glories, remained too focused on preparing young gentlemen for their role in society; college education was for a long time restricted
Quick Review
to a narrow segment of the population. And Britain was late in developing the
•
Countries
differ greatly in their
close ties between academics and industry that did so much to drive the Second
growth rates of real GDP per
Industrial Revolution in both America and Germany. These barriers to educacapita due to differences in the
tion and skill acquisition placed Britain at a human capital disadvantage.
rates at which they accumulate
The good news for today’s British residents is that most of these problems
physical capital and human
lie well in the past. Currently, young Britons are slightly more likely than their
capital as well as differences in
technological progress. A prime
American counterparts to receive a college education. British real GDP per capita
cause of differences in growth
is still below U.S. levels, but it has made up part of the gap. And nobody walking
rates is differences in rates of
around London today would consider it a backward-looking city.
Check Your Understanding
9-3
1. Explain the link between a country’s growth rate, its investment spending as a
percent of GDP, and its domestic savings.
domestic sav